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My son will be starting university this fall, and we are planning to make the first withdrawal from his registered education savings plan. However, we are confused about how we should be withdrawing funds. Should we take out our contributions first? The government grants and earnings? Or a combination?

Your confusion about RESPs is understandable. As much as they are a fabulous way to save for your child’s education – and collect some free government grant money in the process – RESPs are also among the most complex investing vehicles ever invented. This becomes especially apparent when it’s time to tap the accumulated funds.

I faced the same dilemma when my own son started university two years ago, and my conclusion was this: Priority should be given to getting the RESP’s grants and earnings out early and in the most tax-efficient way possible, making sure not to leave excess amounts in the plan after the child finishes school, when stiff financial penalties could come into play.

To understand the withdrawal process, it helps to think of an RESP as two buckets of money. One bucket contains the cash you contributed to the account. If you make a withdrawal from this bucket, there are no taxes payable, because you are simply getting your own money back. A withdrawal of contributions can be made at any time, so there’s no reason to take the money out early unless you need it. Might as well leave the contributions in the RESP so they can continue to generate investment earnings.

The second bucket comes with more strings. It contains all the grant money the government chipped in, plus investment earnings the RESP has generated in the form of capital gains, earnings and dividends. If you make a withdrawal from this bucket, it’s called an educational assistance payment (EAP), and it is taxed in the hands of the RESP’s beneficiary, the student.

There are also limits on the size of EAP withdrawals. For full-time students, withdrawals are capped at $5,000 during the first 13 weeks of enrolment. After that, you can request an EAP of any amount (as long as the student doesn’t take a break from school that lasts 12 months or longer). However, if your EAP request exceeds the federal government’s inflation-indexed “annual EAP threshold limit” – which is $25,268 for 2022 – you could be asked to justify your request with a list of school-related expenses.

So why prioritize EAP withdrawals? Well, when a person is in school, he or she often has very little income, so the EAP withdrawal will likely be taxed at a low rate. What’s more, students can claim the tuition tax credit which, when combined with the basic personal amount, means even fairly large EAPs can be withdrawn with little or no tax payable.

As an example, consider a student in Ontario who receives a $20,000 EAP and has $6,000 of tuition expenses. Assuming the student has no other sources of income, he or she would pay just $381 in Ontario tax and no federal tax, according to the Canadian income tax calculator available at TaxTips.ca. That’s equivalent to a tax rate of 1.9 per cent, and it shows why it’s important to make EAP withdrawals while the RESP beneficiary is still in school.

To be clear, I’m not suggesting you should necessarily withdraw every available penny of EAP funds as soon as the beneficiary starts college or university. Depending on the size of the RESP, that could bump the student into a higher tax bracket. Rather, you should time your EAP withdrawals in a way that minimizes tax in any given year and exhausts the grants and earnings by the time the student graduates. You may need to modify the plan if circumstances change. For example, if there is a risk the student will leave school before graduating, the case for front-end loading EAP withdrawals would be even stronger.

The last thing you want is an RESP that still has a large balance of unused grants and investment earnings after the beneficiary has graduated or quit school. In such cases, any remaining grants will have to be repaid and the withdrawal of the investment earnings – called an accumulated income payment (AIP) – is taxable to the RESP subscriber (usually a parent or grandparent) who set up the account. The subscriber must also pay an additional tax of 20 per cent on the AIP withdrawal.

The subscriber can defer the income tax – and avoid the additional 20-per-cent penalty – by transferring up to $50,000 of the AIP into a registered retirement savings plan, but only if sufficient RRSP contribution room is available. The subscriber can also make an EAP withdrawal for up to six months after the beneficiary has stopped going to school.

Every case is different, but as your son prepares to head off to school this fall, your homework is to start thinking about a plan for getting the grants and earnings out of the RESP in a way that minimizes taxes now and avoids regret later.

E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.

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