Question. Hi, I’ve just received a small inheritance, and would like to use it to help save for my child’s education. I’ve spent some of the inheritance already, to take care of some outstanding credit card debts, and have about $20,000 left over that I would like to invest for my son. By the way, my son was born earlier this year, and I currently have no education savings in place for him at this point. I’m wondering, what’s the best way to do this? I’ve been told that an RESP is good for saving, but should I put all the money in right away? Or should I put in some now, and some later?
Answer. Great question, and yes, you’re on the right track – The Registered Education Savings Plan (RESP) is generally the best way to approach education savings.
Before we dig into the specifics of your question, let’s take a quick review. Remember, the rules surrounding RESPs are actually quite complex, so for the purposes of this discussion, we’ll just recap some of the basics.
How exactly does an RESP account work? Some of the basics of the Registered Education Savings Plan include:
- Contributions to an RESP are not tax-deductible. The RESP is unlike the RRSP in this sense, as RRSP contributions are tax-deductible, but RESP contributions are not. This is often described as saying RESP contributions are made with “after-tax dollars.”
- The total lifetime RESP contribution limit is $50,000 per beneficiary (student). In the past, there was an annual limit of $4,000, but this was eliminated about 10 years ago. It is therefore now possible to contribute the entire $50,000 in a single year, for anyone that has the means to do so. Note that we’re not saying it’s necessarily the right thing to do, but rather, that simply that it’s possible to do.
- When money is withdrawn from an RESP, a portion of the withdrawal is taxable, to the student, not the contributor (who is often a parent or grandparent). Original contributions, which were made with after-tax dollars, can be withdrawn tax-free. However, investment growth and government grants (CESG, discussed below) are taxable to the beneficiary (student) when withdrawn.
- Eligible RESP contributions can earn a 20% matching grant from the government. The grant is known as the Canada Education Savings Grant (CESG), which is a 20% matching contribution on the first $2,500 contributed to an RESP each year. The maximum lifetime CESG available is $7,200 per beneficiary (student).
- Investment returns – capital gains, dividends, and interest – are tax-sheltered inside the RESP. That is, all types of investments grow tax-free while inside the RESP, and the tax consequences arise only upon withdrawal.
Ok, now that we’ve reviewed some of the basics about RESPs, let’s return to your question – should you deposit the entire $20,000 into the RESP today, or should you make a series of deposits over time?
First of all, let’s recognize the two key competing factors which make this decision less than obvious: Compound growth, and government grants. So how would each strategy unfold?
Strategy #1 – Maximize tax-free compound growth. Inside the RESP, your investment growth is sheltered from taxes. The more money you can get inside the RESP as quickly as possible, the faster it will grow in a tax-sheltered environment. This strategy would suggest the best approach would be to contribute the $20,000 immediately – get that compound investment growth working for you as soon as possible.
Strategy #2 – Maximize the Canada Education Savings Grant (CESG). The problem with contributing the entire $20,000 at once is that you will receive only $500 of CESG, which is 20% of the first $2,500. On the other hand, by contributing $2,500 per year for the next 8 years, you would receive $500 CESG per year, for a total CESG of $4,000. Strategy #1 therefore means forfeiting $3,500 in free government money. This would suggest the best strategy would be to contribute $2,500 per year for the next 8 years – maximize the CESG.
And the Winner is…
… It depends – mostly upon the assumed rate of return. In this situation, if you earn an average annual return of 5% or more, contributing the entire $20,000 immediately (strategy #1) is better option. However, if your rate of return is, for example, only 3% or 4%, then maximizing the CESG with a series of deposits (strategy #2) would turn out to be more advantageous.
Best of Both Worlds?
Here’s something to consider – do you also have ample contribution room available in your Tax Free Savings Account (TFSA)? If so, you could contribute the entire $20,000 into the TFSA, and then move $2,500 from the TFSA to the RESP each year. By doing so, you harness the power of compound growth and get the entire $20,000 growing tax-free immediately, and yet you also maximize the amount of CESG that can be earned with a $20,000 total RESP contribution.
This strategy would allow you to realize the benefits of both strategies #1 and #2 above, without sacrificing return or CESG. Also, even if TFSA contribution wasn’t available, a similar strategy could be accommodated with a non-registered investment account. In this case, your marginal tax rate (MTR) would also become a factor in the equation.
The mathematics may indicate one strategy is better than another, but in most real life cases, any particular course of action and RESP savings strategy will be determined by your financial means. For example, it makes little sense to say “It’s best to contribute $50,000 as soon as the child is born” if you simply don’t have $50,000 available to contribute.
Complicating matters further, there are different types of RESPs, including individual, family, and group plans, all with different rules, features, and benefits. Which one is best for you? Stay tuned for our future blog post discussing the different types of RESPs, as we help you decide which type of RESP is most appropriate for you and your family.
In the meantime, if you have any other questions about education savings, or any of our other products and services at ModernAdvisor, just ask us.