Informal In-Trust Accounts
Though not very well understood, an ITA can be a useful tool
RESPs receive a lot of press as a great way to save for kid’s future needs. Less well known is the informal in-trust account (ITA). I have one of these set up for each of my children.
Most of the attention paid to in-trust accounts of late has centered on whether these informal trusts will stand up to the scrutiny of the tax man. While formal trusts are highly regulated and come under no threat, they're also extremely expensive. Experts suggest they aren't even worth considering if you less than $75,000 to $100,000 in assets. For smaller amounts, the informal trust makes much more sense.
The problems with ITAs have arisen because of a lack of understanding of what a trust is and how it works. So, here's an explanation in it's simplest form: A trust arises when assets are gifted irrevocably (they can't be taken back) by one individual (referred to as the “donor”) for the benefit of another individual (referred to as the “beneficiary”), and those assets are administered by a third party (the trustee).
Parents who have established ITAs willy-nilly in the past, putting money in and then taking it out as their personal circumstances have changed, are being told in no uncertain terms that the tax man won't put up with such a lackadaisical approach. Since the transfer must take place irrevocably, donors can't take the money back.
The mere threat that the tax man could reverse the “trust” nature of the ITA, creating huge tax liabilities for donor parents, has people running scared. But such terror is an over-reaction. As long as the in-trust account remains within guidelines, all should be fine.
The first step is to create a written record of who will be doing what when it comes to establishing and managing the ITA. Parents need to decide ahead of time who will be providing the money to the ITA and who will be managing the investments held in the account, since this cannot be the same person. Why? Well, both income and capital gains are attributable back to the parent if that parent acts as both the donor and the trustee.
The documentation must specify who the donor is and who will act as trustee. Some advisors go so far as to say that the donor and trustee should not be married (as in a mom and dad) since this may be perceived as being too close a relationship. Their advice is to make the trustee a more distant relative or friend.
For those parents who want to keep financial discussions in the family, the contributions to the ITA should clearly come from the resources of the parent who is the donor so there's no confusion down the road. That means no joint account contributions.
The next step is to make sure the wording on the account is appropriate. “Molly McGoo, in trust” won't cut it. The account should be set up as “Marian McGoo in trust for Molly McGoo”. This clearly states who the trustee is (Marian) and who the beneficiary is (Molly).
The final issue when it comes to using an ITA relates to the investments held. Interest and dividend income earned in an ITA is attributable to the donor until the child turns 18. However, capital gains earned through distribution or disposition of assets are directly attributable to the child. So for an ITA to be tax smart, it must hold investments that are capital gains intensive.
ITAs aren't for everyone. Parents who don't have a strong focus on equity investing won't do themselves any favours by opening up an ITA and buying Canada Savings Bonds since the tax attribution will be expensive. But for those parents who are equity investors, an ITA can provide more flexibility when it comes time for the child to use the money.
Oh yes, keep in mind that as soon as the child comes of age, the money in the ITA automatically becomes his to spend in any way he sees fit. If you have a problem with that, an ITA isn't for you.