Much of finance is like sex. Action now, with consequences later – many of which cannot be undone. Some people figure that out faster than others. Hopefully before getting an unwanted rash.
In this post, we will deal with one of those consequences – saving to educate the fruit of your loins. We recently reviewed the Registered Education Saving Plan (RESP) as a means for doing that. This post focus on how to optimally contribute to your RESP to get the most out of it.
Fear not, fellow nerds, I have made an online RESP calculator to help us.
There are three main factors to optimize in building up your RESP:
- Front load as much as possible, while making sure that you won’t exceed the $50K lifetime contribution limit.
- Spread out contributions of at least $2500/yr over at least 15 years before your progeny turns 18 to maximize the Canada Education Savings Grant (CESG). To do this, you need to start as early as possible.
- Choose your investment mix to optimize returns for your level of risk tolerance.
Effects of Front-loading contributions to your RESP
Let’s look at three scenarios for making contributions. All three have $50000 in lifetime contributions, the same CESG, and assume the same investment return of 7% with 2% inflation for a real return of 5% annually.
|RESP A||RESP B||RESP C|
|Strategy||$2500/yr from birth||$16500 first year, then $2500/yr for 13yrs, then $1000.||$2500/yr for 11 years, then $15000 once, then $2500/yr for 3 more.|
|Total Value at Age 19||$96052||$115701||$99827|
As you can see by comparing A and B, front-loading your contributions and then spreading the rest out results in an extra 18K due to the longer period for investments to grow tax-free. It will also be taxed in the little hands of your offspring when it comes out. That likely means little or no tax compared to your marginal rate.
Situation C is actually mine with my original clone. I did not realize the optimal strategy until researching this for the blog. It is not too late, I can still make an extra 3K by making a larger contribution this year. It also isn’t as bad as it seems. That money not put into the RESP was left invested either in my CCPC or my spouse’s taxable account. So, we made money on it. However, it was not tax-deferred growth like in an RESP.
A valuable lesson in this. I have had four professional advisors in two different firms, none of whom pointed this out to me. It pays to learn about and mind your personal finances, even if you have an advisor.
The effects of spreading out your contributions to maximize your CESG
Households with an annual income over 92K can get a maximum of $500/yr CESG. Those <46K/yr can get up to $600/yr, and those in between can get $550/yr. You can also make up for a previously missed year. For example, you can get $1000 if you did not get any CESG the previous year. The lifetime maximum remains $7200 regardless of household income levels. A lower income family can simply accrue the CESG more quickly.
Let’s plug a few more scenarios into the RESP calculator.
|RESP A||RESP B||RESP D||RESP E|
|Strategy||$2.5K/yr from birth||$16.5K first year, then $2.5K/yr for 13yrs, then $1K||$50K contribution in year of birth||$25K contribution at age 13, then $5K/yr for 5 years|
|Total Value at age 19||$96052||$115701||$127611||$68604|
We have already seen that front-loading RESP B beats a totally spread out contribution like in RESP A.
However, if you had the money sitting around or gifted from a wealthy relative to put $50K in at birth, you have the option of a huge upfront lump sum contribution. This approach could end up with slightly more money in the RESP (RESP D), even though you miss out on the CESG.
This is because of the power of tax-sheltered compound returns. In our scenarios, we are assuming a 7% return on our investments. If you realize lower returns, then this advantage for D can disappear. For example, a 4% return would have both strategies pretty much even. The other factor to consider is that if you have $50K and don’t put it all in the RESP at once, it will be growing in your regular account. The effects of that are variable based on the returns and tax drag. Complex enough, that it will be a separate post. However, as a rule of thumb, never turn down risk-free money that the government gives you.
One big decider between strategy B and D is most likely to be whether you can access the big wad of money to put $50K in the first year. If you get it as a gift or find it in the crack of your couch – great. If not (which would be most of us!), to access that kind of cash could cause you to pay a lot of tax which you would need to factor into the equation.
The CESG is a guaranteed 20% return the year it is put in. That seems a pretty good deal to me. Like everything else in investing, risk and return are related and you need to balance them in your planning.
What the heck happened to poor RESP E – Well, that family of nerds got an Atomic Wedgie from the Trudeau Gang. How can this be???
The parents of RESP E are professionals and have a CCPC.
They kept the money that they were saving for Mini-me’s enrollment in Evil Medical School as retained earnings in their CCPC. They invested that, after paying the paltry 15% small business tax rate and were planning on paying their little prodigy via dividends when it was time for them to go to school. They could have received $35K/yr whilst paying only $750 in taxes while enjoying the increased flexibility of a CCPC.
Unfortunately, effective 2018, they are no longer able to pay their adult offspring dividends unless they actually work over 20h/week for the corp. Now, they are stuck trying to save using an RESP. They can never make up for the lost tax-free investment time. They can make up some of the CESG money by contributing $5K/yr to get a maximum of $1K CESG/yr until the end of the year that their child turns 17. Those starting the RESP after age ten will miss out on some CESG.
This is a good example of “political risk” from concentrating your portfolio in one type of account.
The government can unilaterally change the rules as they did in this case. They are likely to do so again, as they seek more revenue in the future. All we can do is operate under the current rules, but when there are multiple strategies with similar results, it may be wise to spread out your risk amongst different options as long as it is part of a cohesive overall plan.