Family Finance

Save for your child’s education by opening a formal trust

Last month we looked at creating an informal trust as a way to save for your child’s education. This month we’ll look at formal trusts and how they allow you to invest in your child’s future. Click here for a comprehensive overview on financing your child’s education.

What is a formal trust?

Unlike an informal trust which you simply set up with a financial institution, a formal trust is created by a binding legal document known as a trust deed. This document clearly identifies the person establishing the trust (the settlor), and the trustee who oversees it on behalf of the beneficiaries – in this case children who go on to college or university.

A formal trust should be considered if the amount of money being set aside for the children is substantial – usually more than $150,000. Smaller amounts can easily be invested as an informal trust or through a Registered Education Savings Plan. That’s because the formal trust deed must be set up through a legal advisor, and that can be costly.

The trust deed or contract must specify how the assets are to be managed, how long the trust will exist, and when income and capital earned in the fund is to be paid out. There will usually also be a clause in the deed that instructs how the trust funds are to be used if the children do not go on to higher education. A trust established by a settlor during his or her lifetime is an “intervivos” trust, and one established upon the death of the settlor is a “testamentary” trust.

How do you invest in a formal trust?

The trust deed will instruct the trustee on how the investments must be invested – or may give the trustee the right to decide on how investments will be made. Among the factors that must be considered when setting up a formal trust:

• Whether or not interest and dividends earned in the trust are distributed to the beneficiaries (in this case a child who is going to university or college). If so, that income will be taxed in the hands of the child if 18 or older. But if the child is under 18, interest and dividends are attributed back to the parent for tax purposes.
• Capital gains can usually be taxed in the hands of the child. This is important when it comes to saving for education, because approximately $19,000 (Ontario) in capital gains can be covered annually by the child’s tax credits, assuming that the child has no other income.
• Undistributed capital gains will be taxed in the trust, which is a separate taxpayer. A trust established as an intervivos trust will be taxed at the highest marginal tax rate, excluding provincial surtaxes in the province where the trust is established. If the trust is a testamentary trust, then the rate of tax is graduated as it is for an individual taxpayer.
• Investments can be made in any type of assets, however the trustee must always invest based on liquidity needs, how long the trust will exist, the risk tolerance of the beneficiaries and the best interests of the trust beneficiaries.

Advantages of formal trusts

• All assets in the trust are controlled by the trustee. If structured correctly, there is no risk of a child obtaining the rights to the assets at the age of majority and using them for non-educational purposes.
• The assets in the trust do not form part of an individual’s estate, and therefore no probate fees are paid on the assets at the time death.
• Income splitting is possible among beneficiaries, or between beneficiaries and the trust.
• Potential problems with the Canada Revenue Agency are reduced because the purpose of the trust and how assets in the trust are to be used is clearly set out.
• The existence of a trust deed ensures that the wishes of the person creating the trust are carried out.

Disadvantages of formal trusts

• Set-up costs are more expensive than for an informal trust because a lawyer or notary is required to create the trust deed, and these costs can vary according to complexity of the terms of the trust.
• There is limited opportunity for income splitting, unless the trustee is allowed by the trust deed to allocate income and capital to various beneficiaries in a manner that allows for maximum income splitting (higher taxes to a low-income beneficiary and less tax to a more highly taxed beneficiary who may be working while in school).
• The person who creates, and funds the trust loses control of those assets to the trustee who will have legal title to them, unless the person who creates the trust also acts as trustee.