We all want our kids to work hard in school, get good grades and go to university. In order for this to come to fruition someone has to foot the bill for things such as tuition and books. Parents who do their homework discover that the keys to success for education planning are to start early, save consistently and take advantage of tax-sheltered plans such as a registered education savings plan (RESP). Unfortunately, families with cross-border implications, such as having a U.S. citizen in the family or moving to the United States, face numerous cross-border income-tax traps associated with saving for their children’s education.
The RESP offers two key advantages. The first is that the government will match 20 per cent of the first $2,500 contributed to an RESP on an annual basis up to a maximum of $500. The second is that the income within the plan grows tax deferred. When the funds are eventually used for the child’s postsecondary education, the income is taxed in the student’s hands, resulting in little to no tax.
U.S. citizens living in Canada
As you may know, U.S. citizens are taxed on their worldwide income regardless of where they reside. This results in U.S. citizens living in Canada having to contend with both the Canadian and the U.S. tax systems. Applying this concept to RESPs, U.S. citizens living in Canada are concerned when they discover the U.S. tax system does not recognize the tax advantages of an RESP. In fact, the Internal Revenue Service (IRS) views RESPs as foreign trusts.
There are fundamentally two issues with U.S. taxpayers being subscribers of RESPs. The first has to do with tax filings. Since the RESP is considered a foreign trust from a U.S. perspective, complicated filings (IRS forms 3520 and 3520-A) are required on an annual basis. Penalties for non-compliance can be quite punitive. The second issue is the U.S. tax treatment. If the RESP subscriber is a U.S. taxpayer (U.S. citizen, U.S. green-card holder or U.S. resident) then the government grants are taxable and the income earned within the RESP doesn’t benefit from the tax deferral.
One simple solution to this thorny problem is to have the non-U.S. spouse be the subscriber of the RESP. If both parents are U.S. citizens, consider having another non-U.S. family member such as a grandparent be the subscriber.
For families where this isn’t an option, an interesting workaround is for the parents to gift money to a U.S. resident family member or friend who can then open up a 529 plan for the child. A 529 plan is a U.S. education savings plan. There are no government grants, but it does offer tax-free growth and tax-free withdrawals if the money is used for qualified education expenses. One thing to be mindful of is that U.S. citizen parents need to be careful not to exceed annual gifting limits or they may be subject to a U.S. gift tax.
For families where this isn’t an option, there is a case to be made that having the RESP is still worth it. That is because tax on the grants is better than no grants at all. However when you factor in the cost to pay your cross-border tax preparer to do the 3520 and 3520-A each year, you may not come out ahead.
Moving to the U.S.
Deciding what to do with the RESP can be challenging when moving to the U.S. Non-residents of Canada are not forced to collapse the plan, but the RESP is now subject to the U.S. foreign-trust rules explained above. In addition, while the beneficiary is not a Canadian resident, no contributions can be made; and when they go to university, they cannot take advantage of the funds in the plan.
Collapsing the plan means giving back the grants and paying tax on the growth. Depending on the plan, there may be penalties as well. Factors such as how much money is already in the plan, the age of the children and whether or not the move to the U.S. is temporary or not all factor into making the right decision for the family.
U.S. taxation can create complexities and undermine the intended benefits of the Canadian tax-advantage plan. Without a well thought-out cross-border financial plan, families in a cross-border context may end up with an “F” in planning for their children’s education.
Matt Altro is the president and CEO of MCA Cross Border Advisors Inc. and a certified financial planner in Canada and the United States. David Altro is the managing partner of Altro LLP, which specializes in cross-border tax and estate planning, real estate and immigration and has offices in Canada and the United States.