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Andy Wong
Monday, January 21, 2008
Last week's Tax Break (January 15, 2008) looked at the nuts and bolts of the innovative Registered Disability Savings Plan (RDSP) that provides long-term financial aid to Canadians with disabilities starting in 2008.
This week's article discusses why you should set up an RDSP - and the big trap for the unwary. But first, a quick recap: you put money into an RDSP to support a disabled child. Your contributions, while not deductible to you, are matched by federal grants. Low-income families also receive an additional bond. Altogether, an RDSP could receive up to $70,000 in grants and $20,000 in bonds.
Any Canadian who qualifies to claim the Disability Tax Credit can set up an RDSP. If the disabled individual is a minor (under age 18), the parent, grandparent or guardian sets up the RDSP with the disabled child as the beneficiary. If you are an adult with a disability, you set up your own plan and are the beneficiary.
Setting up an RDSP has no downside and a huge upside because of the generous grants and bonds. As well, the investment income in the plan grows tax-free, and your disabled child (not you) pays tax when the grant, bonds or investment income are withdrawn. The contributions can be withdrawn tax-free.
Here's how the plan works. We assume a family with total income (Mom's and Dad's) of $100,000, making annual contributions of $1,500 to an RDSP for their disabled 10-year-old son, James. We also assume James goes on to earn an annual income of $20,000 as an adult (age 18 on) and does not marry.
Under this scenario, during the first seven years while James is a minor, the RDSP grows slowly from the accumulation of annual contributions of $1,500, annual grants of $1,000 and investment income earned in the plan. The RDSP receives no bonds due to the family's high income.
Things start to pop when James becomes an adult at age 18 because at that time his income, not his Mom's and Dad's, is used to calculate the federal grants and bonds. As a result, the annual federal grant jumps to $3,500 (from $1,000) and the plan also receives an annual bond of $1,000 because of James's low income. (If James marries or lives common-law, his spouse's income gets counted and would reduce his annual grants and bonds).
The annual grants and bonds are payable until James reaches age 49, provided his parents continue to make the $1,500 annual contributions. In this example, if you invested the contributions, grants and bonds over the 40-year period, assuming a modest five per cent return, the value of the RDSP would grow to about $600,000 when James reaches age 50- all that from the contribution seed money of $60,000 ($1,500 a year over 40 years)!
There is one catch, not surprisingly. As soon as James makes a withdrawal, the last 10 years of grants, bonds and associated investment income is repaid to the federal government. That's punitive but with a good reason and there is a simple way to avoid it.
The harsh 10-year clawback is there to ensure the RDSP is used to promote long-term retirement savings, i.e., James won't cash out at age 20, etc. It also discourages James from making withdrawals to fund contributions to get more grants and bonds.
If James starts his withdrawals at age 59 (and not earlier), the 10-year clawback won't apply because the federal grants and bonds stopped 10 years ago, when he reached age 49.
You can set up an RDSP at your bank or call your investment broker.
See Canada Revenue Agency's website for more RDSP details: http//www.cra-arc.gc.ca/agency/budget/2007/rdsp-e.html.
Andy Wong is a tax consultant at MacKay LLP, Chartered Accountants in Yellowknife. He can be reached at andrew-wong@yel.mackayllp.ca.
