For those fortunate enough to have the money available upfront to fully fund an RESP, the dilemma becomes how to best do so. Making a large upfront RESP contribution to grow tax-free may outweigh the loss of some of the Canada Education Savings Grant (CESG) for those facing large tax burdens.
In last week’s post, I compared general RESP contribution strategies for investing $50K of cash-in-hand towards education savings. Generally, the $16500 frontloaded RESP contribution plus $2500/yr to also get the full CESG was the winning strategy. Except for those with high rates of return or parental income, where sheltering all $50K asap in the RESP sometimes edged this out. That exercise was to teach the basic principles, but…
The optimal RESP lump sum contribution strategy actually lies between these two extremes.
The optimal strategy is specific to a person’s tax rate, rate of return, and timeline. Michael James mentioned this in a post about the optimal RESP contribution strategy back in 2012 and seemed to effortlessly go through the numbers of an example. However, I still found the underlying mathematical modeling a bit mind-blowing and situation-specific.
So, I have made a convenient online RESP Lump Sum Optimizer tool that can model outcomes customized to these inputs. It can also be found from anywhere on the site in the right sidebar (along with my other calculator creations).
An important note: This post and the optimizer tool are assuming that you have a lump sum to invest in a personal account. Those with a lump sum in a private corporation have some different considerations around the tax drag on investments in a corporate account, the corporate tax deferral benefit, and the tax triggered by passing that money out of the corp and into their personal hands. That will be a future post.
The Effect of Parental Income Level On Optimal Contribution
Those with a lower parental income level benefit less from making large upfront contributions. They can get the maximum CESG faster ($100/yr for incomes under $45K and $50/yr for those between $45K-$90K/yr). That works in their favor.
Plus, they also don’t face much tax drag on the investment returns in their personal taxable account. Avoiding that drag on after-tax returns is what gives the larger lump sum contributions to the tax-sheltered RESP an advantage for those with high marginal tax rates.
The Effect of Investment Return On The Optimal Lump Sum RESP Contribution
As illustrated last week, a higher investment income also benefits from the RESP tax-shelter. The benefit is greatest for the most highly taxed forms of income, like interest. Capital gains oriented investments with little income perform well in a tax-exposed account due to the deferred and favorable taxation on capital gains. So, the asset mix is potentially important.
In the table below are the effects of different return rates on the optimal front-load at different income levels using 2019 Ontario tax rates. The return rates used are from the 30-year historical data of a Canadian-based globally diversified portfolio.
A Shortened Time-Frame Lowers the Optimal RESP Lump Sum Contribution For Some & Raises It For Others
With the competing priorities of debt repayment, retirement saving, and pent-up lifestyle spending, many high-income parents may have a lump sum available a few years later – that they did not have at the birth of their child. This was our situation.
How does a later start change the optimal RESP lump sum? It is interesting [says the guy who writes a finance blog with complicated mathematical models].
Those with higher incomes can benefit more from a larger lump sum as already described. However, the frontloading advantage depends on the balance between more time for tax-free compound returns against the loss of CESG. That balance begins to shift when starting at a later age (shorter time horizon) earlier for those with lower income than the high-income crowd.
Then, at the point where there are a limited number of years to contribute $2500 and get the $500/yr CESG, the optimal lump sum rises. This is because higher upfront contributions are needed to squeeze the full $50K lifetime contribution limit into the RESP before the age of 18. Remember, an RESP is not just about tax deferral. It is also potentially a tax reduction vehicle when the investment income is taxed upon withdrawal in a poor student’s hands instead of the parents.
Better late, than never. But still, even better early.
A couple of footnotes are important to this timeline and investing prioritization dilemma.
For those contributing late – you can only get CESG for contributions before the end of the calendar year that the beneficiary turned 17. Contributions can still be made up to the age of 31, but no CESG added. The full list of RESP contribution rules are in a previous post.
For those worried about over-saving for education and under-saving for retirement.
RESP contributions are not lost to you. The RESP is owned by the subscriber and not the beneficiary. Unused contributions can be taken back, tax-free, as a return of capital. That could be used to top up a TFSA. Unused Investment income in the RESP can often be rolled into an RRSP later also. So, it is not a total loss of the money at the expense of retirement saving if it is not used. That is the technical answer, but your offspring may see it otherwise.
There are also alternative ways to prioritize the competing demands. For example, Dr. Fawcett prioritized paying off his house and used the increased cash flow to educate multiple children. That was even in the more expensive U.S. college system. It shows the power of a healthy income coupled to eliminating debt. Karin Mizgala also lays out some of the general debate points between an RESP vs RRSP in the Canadian context.
Fortunately, most high-income professionals don’t really need to choose one over the other in the long-term. Just the sequence. If we earn income aggressively and don’t overspend for the first few years of practice, physicians can move through this sequence very quickly.
How much does the effort of optimizing an RESP lump sum affect outcome?
The differences are small in the grand scheme of things, but progressively larger for parents with higher incomes. The chart below shows the potential difference in portfolio size from optimization at different income levels. This was with a 5.6%/yr return. It would be greater with a higher or smaller with lower investment return respectively. The overall portfolio size at age 18 in these models was around $140K in nominal dollars. So, the advantage of optimization runs in the 2.5% range.
The natural question to ask is whether it is worth trying to optimize.
In answering that question for myself, I would ask:
How much more time/effort will it take?
With the online RESP Lump Sum Optimizer that I built, it takes about 5 minutes to figure out. That works out to more per hour than I make as a physician. The effort to execute may actually be less than a spread out RESP approach. For example, at a high income-level, the optimization strategy is spread out over 5-6 years. I’d then be finished contributing. Comparatively, a spread out approach takes annual contributions over a more than a decade.
What if I mess up?
The difficulty with any strategy that can change depending on future returns and income is knowing the future! For some business owners, future income is quite unpredictable. For others, like physicians, it is very predictable.
Investment returns can be highly variable. Over-estimating or under-estimating future returns could result in a slightly less optimal outcome relative to the perfect guess. Fortunately, the differences between slight differences in actual return are actually minuscule. The biggest benefit of a lump sum strategy comes from just getting close and having a long investment horizon.
How precisely do you need to augur the future?
Let’s use the example of someone with a parental income of $250K. They predict a future return of 5.6%/yr. Based on that, they make the optimal contribution of $35K followed by $2500/yr for six more years.
If actual returns were only 3.9%, then the optimal lump sum would have only been $32500. Uh, oh.
Well, despite the difference in the optimal lump sum from what they actually did, they would only be off from the optimal outcome by $97 in terms of total portfolio size. That is in nominal dollars (not adjusted for inflation). Eighteen years from now, that will probably be the cost of a latte at Starbucks. Big whoop.
Fortunately, while taking a “best guess” is required for this strategy, it does not have to be precise.
If you are close to the middle part of the curve, the differences are minimal. RESP lump-sum contributions can join the company of horseshoes and hand-grenades; where close is good enough.
The chart that I showed at the beginning of this post for a parent with $220K/yr income could really be modified to this.
You don’t need the precision required to fire proton torpedoes into the exhaust of the port of the Death Star. Again, the biggest mistake people can make with an RESP (besides getting sucked into a fee-laden and restrictive group plan) is holding on too long before pulling the trigger.
Just ask Red Leader how holding out for the perfect shot worked out for him.