In my previous post about how to optimize RESP contributions, I showed that for those who have the money, front-loading the RESP up to $16500, then adding $2500 annually would probably produce the best outcome by combining a longer period of tax-sheltered growth with still getting the maximum
Canada Education Savings Grant (CESG).
One of the points in that article which I think I was a bit misleading and confusing about was that an upfront lump sum $50K contribution could lead to the largest RESP.
It can. However, if you have a $50K lump sum, it is actually an interaction between the RESP value, money invested in a taxable account, tax drag during growth, CESG grants, and taxes upon accessing the money in the various accounts.
That is much more complicated and I honestly thought to myself – who really has $50K laying around anyway? I checked the crack of my couch. Just some lint, loonies, and a desiccated hunk of cheese.
So, I glossed over it. Even though it was far removed from our situation when we had kids during a period of negative net worth and resident income – many people actually do face this dilemma. In this week and next week’s posts, let’s unpack it. I will use lots of pictures to try and make this comprehensible.
Who the heck has $50K for an RESP right out of the birth canal?
There are many reasons why people can have this kind of dough.
For some, it may be a relative who gifts the money. That relative may be wealthy or they may have sacrificed in other ways to prioritize educating the next generation of their DNA-carriers. The money could have been socked away by parents who waited until they were financially established before reproducing. They could be older parents who are having kids later for career, social, or biological reasons. Someone may have a big wad of personal cash from realizing a capital gain selling some real estate.
Plenty of reasons. No judgment or jealousy allowed here. This blog is supposed to be a safe place for people with money.
Whatever the reason, I would call these rich kids. That wealth is a mix of family financial wealth and people who care enough to commit that money at their future education.
What are the strategic options available to invest this wad of cash?
Funding an RESP is mission-specific saving. It has a defined purpose (educational costs) and a probable time-line (late teens plus or minus a “finding-yourself-factor”). A TFSA and RRSP are meant to serve a different purpose – long-term retirement planning. Spousal RRSPs are for retirement planning and income-splitting.
So, the accounts we will look at as options are a personal taxable account and putting the money into an RESP. Many professionals may have their cash stockpiled in their CCPC (like a professional corporation). That adds some variables that we’ll examine in a separate post. An informal trust in the kid’s name could be another option. Again, that comes with its own complexities due to the attribution rules and is beyond the scope of this article.
Strategy #1: No RESP
Just keep the money in a personal taxable investment account. This subjects it to tax drag on the income produced during the accumulation years plus capital gains taxes upon accessing the money down the road. It also forgoes the CESG. Spoiler alert – this one loses. RESPs are good for rich kids.
Strategy #2: Even Annual Contributions
Each year, $2778 is transferred from the taxable account into the RESP. The max CESG is added each year until the lifetime maximum of $7200 is reached.
The taxable account will have been growing and should still have some money left in it after the original $50K has been transferred into the RESP. At the time of educational-need, this can be accessed. There would be some capital gains taxes paid, but there would still be money left over for books and beer. I mean books and extra tutoring.
Strategy #3: Front-loading, then spread out just enough to get full CESG
Invest $16500 upfront into the RESP. The remainder of the money is invested in a personal taxable investment account. Investment income would be taxed in the hands of the account holder. Each year, $2500 plus an amount to pay the tax on any capital gains is taken out and the $2500 put into the RESP.
This is done until the $50K lifetime contribution limit is reached at which point, they will also have received the maximum CESG of $7200.
This is similar to strategy #2 except that it shifts more money for longer tax-free growth in the RESP while still getting the full CESG.
Strategy #4: Lump Sum
All $50K is dumped into the RESP. If done immediately at birth, then you get $500 CESG. If you can wait until their first January, then it is $1000 because you can get the current calendar year plus the unused grant from the previous year. The rest of the CESG is lost.
The success of this strategy relies on a higher compounding rate of return in the RESP due to the lack of tax drag. When the money is taken out of the RESP, even though the accumulated investment income would be taxable, most students can drain their RESPs with little or no tax. I reviewed tips for liquifying an RESP previously.
Can these factors make up for the lost CESG? It depends.
Effect of Parental Income On Strategy Outcome
As seen above, not taking advantage of an RESP in any way was a losing strategy in this situation. Regardless of income level. The front-loading strategy also beat out evenly spaced contributions at any income level. If you have the money, shelter it asap. Of course, that should not be at the expense of losing free government grants.
Unless your tax rate is insane. Michael James did a really nice analysis of the question we are looking at today back in 2012. He concluded that a $50K lump sum strategy loses compared to getting at least some of the CESG under any “sensible” return and tax assumptions.
That was in 2012 and since then we now have new high-income tax brackets from provincial and the federal governments hitting a harrowing 54% top marginal rate. It is debatable whether that is a sensible tax rate or not. Irrespective of that judgment, with a sensible 5.6% return, those in the Trudeau 220 bracket may have an advantage from the tax-sheltering of the full lump sum. How about with different rates of return?
Effects of Investment Return On RESP Contribution Strategy Outcome
Those who have higher incomes pay more tax. Therefore, they also benefit more from the tax-deferral of an RESP and the tax reduction when the money is taken out almost tax-free by their progeny. Similarly, if the investment income is higher, then it benefits more from the tax advantages of an RESP.
For the above modeling, I used the portfolio with estimated returns described below. This is a screenshot of this section of the online RESP contribution calculator that I just revamped for making this post. Ontario 2019 rates and a personal income of $220K/yr are used for the taxable account.
The asset allocation and estimated rates of return are adjustable. I used that feature to compare the Front-loading and Lump Sum RESP contribution strategies at different rates of return and at different income levels. As you can see below, a Lump Sum strategy can start to edge out the Frontload strategy after taxes are accounted for when returns exceed around 5% for those with high incomes.
You will note that I have been conservative in the rates of return that I have used. Historically, a 60:40 stock bonds portfolio has actually returned close to 9%/yr over the past decade. So, it is not outrageous that you may beat 5%/yr. However, a look at a longer 30-yr time frame shows that I am not too far off. You can use my Canadian historical return and volatility visualizer to test different asset allocations over the 1988-2018 time-frame.
The effect of a shortened time-frame on RESP strategy
Using a larger upfront contribution and foregoing some of the CESG requires a longer time frame to be successful. The CESG is a 20% immediate return on investment while a $50K lump sum approach needs time for the magic of tax-sheltered compound returns to outpace that. As seen below, with a delayed start of 5 years, the slight advantage of a $50K lump sum over the $16500 front-loading strategy is gone.
The math is nice, but I still favor the Frontload approach. Why?
We personally fall into the highest marginal tax bracket. However, we have used a front-loading approach. Well, we did it a few years late because we didn’t have the money when our kids were born to do more. I still don’t regret that. There are several reasons why.
Successful investing is about risk and reward. Whether we can achieve a long-term annual return over 5% is a risk. The CESG is a guaranteed return.
To achieve high returns, one would need to take on significant investment risk. That means volatile, but higher returning assets. This comes back to the mission of an RESP. Volatility and higher returns are not a big issue, in fact, are desirable – with a long timeline. Such as retirement saving.
The timeline for an RESP is defined and shorter. There is also not as much flexibility as to the goal and deadline. It would be unpleasant if we needed to sell investments from an all-equity portfolio during a market crash to pay for tuition or student housing.
Early on, a high equity allocation is likely fine. However, as the time where we will need the money approaches, we would want to have more fixed income in there. So that we know that it will be there when we need it. The optimal asset allocation at any given time for an RESP is a bit fuzzy. The best asset allocation formula for an RESP is similar to the A-a gradient equation from medical school:
Editorial Note: There is a comment below from Park about the alternative way to look at RESP investment risk strategy/time-line for those anticipated to have plenty of financial reserve when their beneficiaries are in school. Worth reading.
Final Reason: The frontloading approach can be optimized further!
In this post, I used the commonly referenced approach of frontloading $16.5K, followed by $2.5K/yr for 13 years, and then $1K. That maximizes the CESG. However, as shown in this post, it is actually an interplay between parental tax rate, investment returns, and timeline that affects the balance between tax-sheltered compounding vs. a loss of CESG.
For most high-income parents, the optimal frontload is actually somewhere between $16.5K and 50K. Optimizing the Frontloading approach will be next week’s post.
It is also important to note that this optimal lump sum discussion is about money available in a personal account.
Money that needs to be taken out of a corporate account (losing the partial tax deferral) is a different story. That will be a separate post.
Don’t like my projected returns or Ontario tax rates? Input your own.
Plug your own numbers into my online RESP contributions calculator and see how it could pan out.
There is an option for regular people who need to come up with the money for an RESP each year. And one for the rich kids who have $50K sitting around in some form or another. It has tax calculators running in the background for each province.
Annual tax drag on different investment income types and tax on the proportion of capital gains realized when money is transferred from a taxable account into an RESP are accounted for automatically. The tax upon extraction is also factored in for the parental income level and the student income tax bill is assumed to be zero. The associated online RESP withdrawal calculator can show how that could work.
There is even the option to consider lump sums currently sitting within a private corporation. Another factor that affected our personal strategy was the fact that we are incorporated. We can invest efficiently within our corporation with partial tax-deferral. I will examine the impact of that additional layer with another post about RESPs for Corporate Kids.