Wednesday, July 25, 2007

Reader's Question #6 - Part II

During last week I started to answer a long reader's question. Here is part II of that question.

Q:My father-in-law wanted to gift each grandchild $25,000 while he was alive. Due to a sudden decline in health he never got around to doing this. We are going to gift the money as per his wishes even though it is not in the Will. Our initial plan was to put it in an Informal Trust with the Financial Planner. Now I want to avoid him and do any future investing ourselves. I am very interested in Index Funds and not confident enough to jump into Exchange Traded Funds yet. But my understanding is that they are not great for taxable investment money because as the Index changes and the Fund is updated, Capital Gains are earned. Given that this money will belong to our children, we don't want it subject to tax in our hands.

In your opinion, how would an investor best take advantage of the Market to set up an investment on behalf of their children(ages six and four years and two months old). RESP's are already in place.

A: Really good question. How do you invest for your children if you already got the RESP in place and got enough in there to max out your Canada Education Savings Grant? An Informal Trust could be a good option yet they do present some issues you need to know about and fully understand (See this page from the Canadian Banker's Association - you will need to scroll down to near the bottom).

An informal trust is set up to provide taxable invests to a child which they will receive control of those assets once they hit the age of majority. To set one up you need three people: one person to donate the money, one to administer the money and the third person is the child which will benefit from the money. The trust income is taxable, but depending on what type will either be taxable in the donor's hand or the child's. Since the child can use the basic personal tax deduction they can typically get the invest income tax free or with low tax. The trick to all of this to ensure the income is coming in the correct form to avoid being taxed in the donor's hands. For example interest and dividend income is taxed in the donor's hands, while reinvested interest and dividend income and capital gains are typically not taxed in the donor's name if the trust is set up properly.

So overall the informal trust is a good format since you don't have any limits on money you can invest and if you keep the income from it low you can avoid tax in the donor's hands. Also the trust can be used for anything, it is not tied to the child's education. Yet there is also bit of downside that after the child is the age of majority you have no legal say on what they spend the trust money on.

As on how to setup the investments within the account I suggest you step back a minute and look a the big picture. You have two accounts for each child. One tax deferred (RESP) and one taxable (Informal Trust). So you want to take advantage of this fact to child's benefit. The best way to do this is make sure all the stable interest portion of the child's money is put in the RESP account to defer tax on that interest and then have all your capital gain and dividend income in your informal trust. Why both the capital gain and dividend income in the trust? They are often hard to separate. If you have one, you typically have the other in a fund. So the risk is the donor may get taxed on some dividend income, yet if you place this in the lowing income spouse's name there shouldn't be too much tax paid overall.

Generally this is complex issue that you will need to seek some professional consul on to ensure you minimize everyone's tax bill. As to the exact blend of investments to use, it is always a bit of challenge picking them out for kids. Since there is typically a shorter time horizon involved (less than 20 years) you want to ensure you stay fairly conservative overall. Index funds can be used, but keep in mind you will also have to be adjusting the balance on the account to become more conservative over time. I'm currently in a Dividend Mutual Fund for my son and we are going to start shifting over part of it to more conservative investments by age 5. At that point 25% of the account will be changed over. After that I'll move an additional 5% a year to more conservative investments, so by the time he turns 18 most of his RESP money will be in low risk investments. In your case you will need to do something similar, but over two different accounts.

I hope all that helps.


FourPillars said...

Interesting post.

I think your comment about adjusting the portfolio asset allocation over time to make it more conservative as the investment horizon gets smaller is valid for the resp but not for the trust. Just because the child gets control of the money at age 18?, 21? doesn't mean they are going to spend it right away. If they want to use the money for a house downpayment then that might not happen until their mid-20's or later.

Thicken My Wallet said...

Wow, your readers don't give you easy questions do they?

I would be really concerned about the fact that the "gift" was never in the will- if there are our beneficiaries to the grand-father's estate, you have some serious issues gifting the money not specifically provided for in a will. If the estate has not been probated or an estate tax levied then the children do not get $25,000. They get that amount less than the probate/estate tax.

The larger issue is that the reader has an extremely complicated financial situation and seems to distrust her investment advisor. I would suggest that her first step would be to set up a team of professionals she trusts before getting to the specifics. She seems to be putting the cart before the horse in seeking tactical answers without a larger strategy. Pensions and informal trusts are fraught with danger if not handled properly (and there's the will issue above- maybe I am missing something but you simply cannot give money to someone who is not named in the will). I would strongly suggest that she talk to an accountant first before doing anything.

Canadian Dream said...


True if the time line is longer it doesn't have to be that conservative, but in reality after the child is of age (18 I believe) it is the child's choice not the parent's choice to change things.


What would be the fun if I only got easy questions? *laugh*

Actually there isn't any issue with the will. It's done and gone. The parents currently have all the money and want to give it to their children as mentioned in the question. So this cuts down on some of the complications around the will, but increases issues around setting up the trusts.

I agree that an accountant should get involved as this could get messy very quickly.