Enhancing financial growth through re-investment

Not everyone who purchases investments wants or needs the income today.  In many they’re trying to grow a nest egg to fund a future goal, such as retirement.  These investors may want to see more growth in their portfolios and may not be attracted to investments that pay investment income.

Many investments have both a growth and income component.  Fortunately most of these same companies offer the dividend reinvestment program – often referred to as a “DRIP.”  Growth is often achieved through price appreciation of the investment and also reinvesting the income.

DRIP Illustration

An investor purchased 400 shares of the common shares of ABC Corporation currently trading at $30.  The current quarterly dividend is set at .25 per share.   Based on these values, when the dividend is payable, the investor would receive (400 x .25 / $30) approximately 3 shares of ABC and $10 cash.  After the dividend the investor would own 403 shares.

Tax Effect

Although the investor above may have requested that their dividends be reinvested, the dividend income will still be considered income for taxable accounts in the year the dividend was declared.  Investors will receive the applicable taxation slips and should ensure they have sufficient cash on hand at the end of the year to pay any tax liability.  DRIPs in an RRSP account are ideal as any income is deferred and is not taxed immediately.

Adjusted Cost

The DRIP program has investors acquiring shares at different prices with each dividend being reinvested.  For taxable accounts it is important to keep track of the costs at which the new units were reinvested.  The cost of the original purchase plus the total value of the shares reinvested on the date of the DRIP equals the adjusted cost base.

Commissions

There are no commission charges for the DRIP program.  Certain investments automatically reinvest distributions without being set up under the DRIP program.  Many investments do not have a DRIP program.  Investors can provide their investment advisor a copy of their statement and request which positions are eligible to be set up as a DRIP.

Fractional Shares

Unlike mutual funds, it is not possible to have fractional shares of common shares.  The illustration above highlights that the fractional portion (less than the amount to purchase a whole share) is paid as cash into the investment account.  Stock splits are generally a good thing for individuals that have the DRIP program.  Share prices are generally reduced resulting in a greater portion of the dividend being reinvested.

Odd Lots

Years ago investors were warned that they may have difficulties selling shares of companies if they had an odd lot.  A lot is generally considered 100 shares.  One can easily see how the DRIP program would result in an odd lot situation.  Today this is less of a concern for any position that has a moderate volume of shares traded daily.  With reorganization, spin-offs and computerized trade execution many investors have odd lot holdings.

Position Size

Investors should take care to monitor their position sizes.  Investors may find over time that certain positions that are set up as a DRIP may become overweight within their overall portfolio.  Investors who have charitable intentions may want to consider donating shares or sell a portion of their holdings as a means to rebalance the portfolio.

Cancellation

A DRIP can easily be cancelled.  An investor may want to cancel a DRIP when they begin to require income from their investments.

Growth oriented investors may find the DRIP a low maintenance way of dollar cost averaging while reducing the costs of investing and employing cash that may otherwise be earning a low return in an account.  The DRIP allows compounding of investment returns which can enhance total returns.

Education can be costly

The Cost of Raising a Child

The greatest cost in raising children may potentially be the cost of education.  There are several ways to fund a child’s post secondary education.  One way might be to anticipate that a child will receive scholarships or use student loans, while other parents may decide to pay as they go.

Whichever method parents choose to assist their children it is important to keep a mental note of the potential costs for budgeting your cash flows.  Like all plans, your future costs should also factor in the unexpected.  An unanticipated disability, death, divorce or other family emergency may interfere with your children obtaining an education.  In many cases purchasing adequate insurance may offset some of the risk if a supporting spouse were to become disabled, suffer a critical illness or pass away.

Today, many young parents are struggling to make ends meet.  Paying the household bills, including the mortgage leaves little left over for education planning.  Contributing to RRSPs provides a deduction from taxable income whereas RESPs do not provide this immediate tax relief.  Last week we discussed the basics of RESPs and the following outlines a few points to consider when looking at an RESP for a child.

Attribution Rules:  Normally, when you give your minor child money, interest or dividends earned on this money is taxed as if you had received the income (i.e. income is attributed back to the parent and taxed in their hands).  Capital gains income does not attribute back to the parents.  The attribution rules do not apply to RESP contributions.

Planning Contributions:  It may be very difficult for parents to contribute $2,000 every year.  Although the compounding component to investment returns is important, it is only one factor to consider.  Contributing a smaller amount, say $1,000 beginning immediately, is one option.  Another option may be to wait until your child is older and then contribute a greater amount, up to the yearly maximum of $4,000.  Both possibilities enable you to take advantage of the Canada Education Savings Grant (CESG).

Pre-Authorized Contributions:  Setting up a monthly pre-authorized contribution (PAC) is often the easiest way for a family to get started with investing.  Benefits of a PAC include dollar-cost averaging and the benefits of compounding over the long term.  Every month the CESG is paid based on a minimum of 20 per cent of the preceding months contributions.  Some financial institutions may not have systems in place to administer frequent contributions to RESPs.  The timing of the CESG payment may differ between financial institutions.

CESG:  The CESG is at least 20 per cent of contributions to a maximum of $4,000 annually or a lifetime total benefit of $7,200.  Utililizing the $7,200 CESG is a prudent move as this investment effectively provides a minimum 20% return upon contribution into the plan.  Although individuals may make a lifetime contribution up to $42,000 into an RESP they are effectively only obtaining the grant on the first $36,000.  If you multiply $36,000 x 20% you obtain the maximum CESG of $7,200.  The CESG makes RESPs for children very attractive.  Contributions over $36,000 are less appealing.

Grandparents:  Many grandparents are proud to start the next generation off on the right foot.  Funding an RESP is a great way to help both their children and grandchildren.  Godparents, friends and other family members may also be the subscriber of an RESP for a child.

Individual vs Family:  An individual plan is set up for the benefit of one person. A family plan is set up to allow contributions to be made for more than one beneficiary. The one condition is that all the beneficiaries must be related to the contributor(s) by blood, but not nieces or nephews.  Contributors decide on how the plan’s assets are invested along with the timing and amount of the education payments. The main benefit of a family plan is that RESP income does not have to be paid out proportionately between beneficiaries. If one child does not pursue post-secondary education, the other beneficiaries may use the income for their education.

Student Tax Initiatives:  The 2006 federal budget contained a number of proposed changes to personal income tax, some of which affect students.  For 2006 and future years, a non-refundable textbook tax credit will be introduced for post-secondary students.  The credit will be calculated with reference to the lowest personal tax rate and will be in addition to the current education tax credit.  Textbook tax credits are able to be carried forward and have the same transfer rules as tuition and the education tax credit.  For 2006 and subsequent years scholarship, fellowship and bursary income will be fully exempt from tax with respect to post-secondary education and occupational training.

The First Step:  In order to get started with an RESP today, a child needs to request a social insurance number.  An excellent source for information is www.servicecanada.gc.ca which includes information for parents.  The Human Resources and Social Development (HRSD) website at www.sdc.gc.ca also provides detailed information on obtaining a SIN for the first time.  The website enables you to download a current SIN application form.  To locate an office near where you live to pick up and/or drop off forms call 1-800-OCanada (1-800-622-6232).

Applying in person, rather than mailing the application, may be faster and more convenient.  Another benefit of applying in person is that you are not required to part with your identification documents because your identification is verified at that time.  If you obtain an application form from another source or financial institution, you should ensure that the form is current.  The application process normally takes three to four weeks before you receive the physical card provided that your application meets all criteria.  In extenuating circumstances, a SIN may be obtained verbally in a shorter period with the physical card to follow at a later date.

With the combination of tax sheltering and the CESG, an RESP may play an important role in your family’s education savings strategy.

RESP 101 – It pays to gain RESP education

What is an RESP?  Registered Education Savings Plans are registered accounts that enable you to make contributions now towards the cost of future education.   Unlike an RRSP, your contributions are not tax deductible.  Investments within an RESP have the potential to grow and income is tax-sheltered until paid out to the beneficiary.  RESPs may be very attractive for those beneficiaries who qualify for the Canada Education Savings Grant.

The Good News: Previously the rules governing an RESP were onerous. If the beneficiary did not attend a qualifying institution (i.e. college or university), any growth, interest, dividends and capital gains went to the educational institution that was designated on your RESP contract.  The good news is that the Canada Revenue Agency has significantly modified the RESP rules. In addition to the tax advantages, there are increased savings limits and additional termination options.

General Rules:  Although contributions to an RESP are not tax deductible, any income within the plan compounds on a tax deferred basis. Furthermore, when the accumulated income is withdrawn from the plan to pay for education expenses, the student pays the taxes, not the contributor.  In most cases, this income would attract little tax because the student’s basic personal exemption along with tuition and education credits help to offset the tax liability.  Any individual can set up an RESP including grandparents, aunts, uncles, godparents and friends.

Contributions:  These plans allow the contributor (called a subscriber) to deposit any amount up to $4,000 annually per beneficiary.  Contributions may be made for up to 21 years following the year in which the plan is entered into, to a lifetime maximum of $42,000 per beneficiary. If these limits are exceeded, a one per cent per month penalty tax is charged until the over-contributed amount is withdrawn from the plan.

Canada Education Savings Grant (CESG):  The CESG grant was introduced in the 1998 federal budget.  Currently, beneficiaries are not required to have an existing RESP to accumulate CESG contribution room. Under this program the Government of Canada pays a grant of at least 20 per cent of the first $2,000 of annual contributions, directly into the qualifying beneficiary’s RESP.  Qualifying beneficiaries are generally below the age of 18 and may receive a lifetime maximum CESG totaling $7,200 per beneficiary.  Contributions for beneficiaries aged 16 and 17 will only receive a CESG subject to certain stipulations. CESG room may be carried forward until the beneficiary turns 18.  Beneficiaries must have a social insurance number to receive the CESG.  If contributions are not made to the plan then the CESG contribution room may be carried forward and used when RESP contributions are made in future years.

Education Assistance Payments (EAP):  Once the beneficiary of an RESP is enrolled in a qualified school, education assistance payments may commence.  Any income or growth earned within the plan may be paid out to the beneficiary once they are attending a recognized post-secondary institution.  EAPs are taxed in the hands of the beneficiary, who reports it as “other income” on their tax return.

No Post Secondary?  If the beneficiary of the RESP does not proceed with post secondary education, the contributions are returned to the contributor with no tax consequences and the CESG, if applicable, is returned to the government. Contributors may withdraw the income earned in the RESP if the following criteria are met:  (1) all beneficiaries named in the plan are at least 21 year old and are not eligible for EAP payments; (2) contributor is a Canadian resident and ;(3) RESP was opened at least ten years ago.   These income withdrawals are referred to as Accumulated Income Payments.

Accumulated Income Payment (AIP):  Provided the above three criteria are met, the Accumulated Income Payment that has not been paid out to the beneficiary can be returned to the contributor by either: (1) transferring up to $50,000 to the contributor’s RRSP or a spousal RRSP (the contributor must have sufficient RRSP contribution room available);(2) having it taxed in the contributor’s hands at their marginal rate plus an additional 20% tax is levied; (3) donating the income to a post-secondary institution (no donation tax credit provided).

Maturity:  An RESP has to be terminated on or before the last day of the twenty-fifth year after the year in which the plan was entered into.  The consequence of this deadline is similar to the beneficiary deciding not to pursue post-secondary education.  All contributions will be returned tax-free to the contributor and the CESG repaid to the government.  Any income that has not been paid out to the beneficiary must be returned to the contributor as an AIP.

An RESP is one of several vehicles individuals may choose to help fund post secondary education.  Rules are continually changing with respect to RESPs.  Individuals should always consult with their personal tax advisors before taking any action based upon these columns.