The preceding post examined the basics of how an RESP works. It is an excellent tool amongst multiple options to plan for the training costs that may be required to launch your fledging from the nest. The most important ways to optimize your RESP are to open a self-directed account (rather than join a group plan) and to get started early. However, there are other ways to optimize RESP contributions and unlock its full potential. The best strategy depends on your larger financial situation, personality, and preferences. Learn more to decide where an RESP fits into your financial plan and choose an RESP contribution strategy that is optimal for you.
Consider How Your RESP Fits Into Your Financial Life
We are all human. That means we naturally divide information into individual packets, even though they are all part of the same meal. This is called mental accounting and while natural, it is illogical. For the most logical attempt at optimizing our finances, we must consider them as a whole. Think like a Vulcan.
Why consider your RESP in a broader context?
We are especially vulnerable to mental accounting when we are considering RESPs. We think of it as our kids’ money and for the specific mission of funding their education.
However, the reality is that we can draw from multiple pots to fund our kids’ education. For example, we could draw from our excess income, savings, debt, or other investment accounts at the time we need the money.
To illustrate, putting extra money in an RESP beyond the minimum required for grants when you have high-interest debt is illogical. Instead, you could build a more stable platform. Then you will be in a stronger position later to help, using your improved cash flow, or building a larger TFSA to draw from.
So, if you want to make a mathematically optimal RESP contribution plan then consider your overall finances as one. That said, there is still an argument to consider an RESP in isolation.
When does reality trump logic?
If it is behaviorally the only way that you are going to set aside money and not touch it, then consider the RESP on its own. Protect it from your human shortcomings. If you are unlikely to have extra income, savings, or other accessible investments at the time your progeny needs the money – then build and protect your RESP in isolation. Do not waste energy juggling choices that you may not have. Just take action.
The outcome of any financial strategy depends not only upon the math, but also upon the execution. The further into the future and the more complex it is, the more important execution risk becomes. For those with the flexibility and discipline to consider optimization, the strategy is still dictated by your overall financial life. While not an exhaustive approach, here is an overview of some common situations.
So many competing priorities. So little money.
This is by far the most common scenario for the average Canadian. Even as a high-income professional, this was our financial situation when we popped our kids out. Debt, pent-up demand, career, and the fertile-years commonly coincide. In this situation, the priority is to scrape together an RESP contribution large enough to get the full CESG each year. That is a $2500/yr contribution, or possibly $5K/yr if you are behind. You may even be able to get a CLB before your training or business venture pays off and boosts your income.
I fully appreciate the pain of reviewing where the money goes. However, it is the only way to get an accurate idea of how you are spending. That is the first step in cutting the money spent on things you don’t care about to instead spend lavishly on what you do care about. Like educating your kids. Perhaps, even reclaiming your basement one day. To me, budgeting isn’t about being cheap, but about spending to live a rich life.
Strategies To Pay Your Kids First
Well, you do want to pay yourself first too if you have unused tax-sheltered accounts. More on that later. However, the same principle applies. If you automate redirecting money to your priorities first, then you are less likely to spend that money on the less important stuff. That does mean having a budget to make sure you don’t leave yourself short on necessities. However, a simple automated process helps you to reliably execute your plan. Behavior and psychology are critical to outcomes.
Automating Your RESP For Better Behavior
One way to improve your behavior is to set up automatic contributions to your RESP that occur shortly after your payday. For those who get large sums in fits and spurts, like a self-employed professional, then try to make your contribution as early in the calendar year as possible. For example, I do our RESP, TFSA, and RRSP in one sitting each January. Get the money out of sight, out of mind. If it further helps you psychologically, then doing this monthly with Canada Child Benefit payments is another option. Making your plan easy to execute is important whether you have budgetary discipline or not because that cash also needs to be fully invested consistently.
Automating DIY Investing
For a self-directed account using All-In-One ETFs, you still must log in to your brokerage and buy ETFs with the money. If you open an RESP using Qtrade, then XBAL/XGRO/XEQT are free to buy and sell. So, small contributions are okay. I made an interactive guide (with pictures and detailed instructions) on how to do this. If you use my Qtrade Direct Investing link, I do get a small commission at no cost to you and you get their best deal. It is the only advertising I allow on the site. That is because it adds value to you and furthers my mission.
Robo-Advisor: Fully Automated for a small fee.
If you want it even easier, a robo-advisor allows you to set up automatic contributions to your RESP. Plus, it then automatically buys and maintains the account holdings. Total automation. There are many options out there. If you open a Qtrade Guided Portfolio via my link, it is affiliated with The Loonie Doctor which helps fund this site. The fee for a robo-advisor plus the underlying funds is usually ~0.75%/yr to do everything compared to 0.25%/yr to DIY invest using an All-In-One ETF. The right choice for you is a balance between the fee difference and whether that buys you better behavior and convenience.
Mutual Funds: Fully Automated. Humans & buildings ain’t cheap.
A mutual fund is another fully automated option. For mutual funds, the combination of advisor and fund fees is usually 1.5-3%/yr. Look for the management expense ratio (MER) of any fund you are considering. On the plus side, you usually get a human advisor, which may or may not be a good value for you.
$2500 = No Problem. Unused Tax Shelters = Dilemma.
Perhaps your income has picked up and you wisely haven’t stuck your hand into the earning-spending trap. You have repaid your debt to Future-You. However, you also have unused TFSA or RRSP room. Perhaps you are eligible for the new First Home Saving Account (FHSA). An RESP is a great tax shelter, but the other registered accounts are too. They are all part of building your future financial security and the benefits compound from an even longer investment time frame than possible with an RESP. Even if you are all about the kids, your security is theirs too. So, you want to weigh where to put excess cash against those options.
The biggest advantage of an RESP compared to other registered accounts is the CESG gift. So, you almost always want to put in the $2500/kid/year to get the grant and then prioritize excess cash to other accounts until they are filled. After that, the RESP may be the best place again if there is unused room within the $50K/kid lifetime maximum.
Contributions of $36K spread over 8 to 14.5 years are required to get the maximum CESG. So, if you do make extra contributions, be sure that they do not exceed a total of $14K. Unless you are deliberately trying to use a more aggressive lump sum optimization strategy. More on that later.
RESP vs Debt Repayment
This shouldn’t even be a debate if you have high-interest debt or debt that is keeping you awake at night. If that is the case, then prioritize paying it off with your extra cash. If you are on a secure footing to absorb cashflow shocks, then you can consider putting extra into your RESP. For the first $2500, the grants plus tax sheltering make an RESP a winner with an instant 20% risk-free return. After that, the tax shelter of an RESP makes it a closer call in the pay debt vs invest debate for additional contributions. Paying debt offers a guaranteed after-tax risk-free return equal to the interest rate.
RESP vs First Home Savings Account
The FHSA just became available as I am writing this post. It is like a house-obsessed child resulting from intercourse between a TFSA and an RRSP. It gives both a deduction against income (tax refund), the invested money then grows tax-free, and then you can take it out tax-free. The only catch is that you (or your spouse if co-habiting) cannot have owned a house in the last five years. If you eventually take the money out to buy a house. No problem. If not, then you could add it to your RRSP. On top of the regular RRSP room.
This beast is a crazy tax gift for those who have money to stash and don’t own real estate. A no-brainer. In comparison to an RESP, I may even be tempted to pass on the RESP contribution for a year to get it going if I was forced to. As long as I could make a larger contribution in the near future to make up for the missed CESG (up to $1000/yr unclaimed CESG for $5000/yr contribution). That translates to a minimum of 8 years contributing to the RESP to avoid permanent CESG loss. You could even take the FHSA tax refund and use that for RESP catch-up money if you need to.
RESP vs TFSA
An RESP and Tax-Free Savings Account (TFSA) are both contributed to with after-tax personal money. Investment income in both is tax-sheltered in the same way. However, the growth in an RESP will be taxed in the hands of the beneficiary on the way out and growth in a TFSA is never taxed. That difference is usually negligible if the student has a low taxable income. However, it is not zero and some students have a significant combination of income from jobs, scholarships, and the Education Assistance Payment portion of their RESP withdrawal.
The other way that a TFSA differs is that you can hold it for your whole life. Money that comes out can go back in. You keep the increased room from investment growth. Hopefully, big compounding growth. This is a major advantage over a lifespan. So, the earlier you start growing the tax haven space in a TFSA, the better.
For these reasons, if I had to choose, I would put $2500 into my RESP and then direct extra personal cash towards unused TFSA room. Just try not to waste the TFSA gift with low growth or high-fee investing. That said, only invest money that you don’t need in the near future. If it is intermediate-term saving that you need and you don’t have the financial capacity for long-term investing yet, then the TFSA is still a good account to use. Just don’t try to use it as a revolving door and don’t forget to shift gears to investing when you do have wiggle room to invest for the long-term.
RESP vs RRSP
An RRSP is most useful if you are in a high personal tax bracket or near your probable peak tax bracket. The reason is that the contributions can be deducted against income. So, a deduction against income in a 54% tax bracket means a 54% refund.
You can contribute now in a lower tax bracket and deduct later if you know your income is going to jump. However, if you have the option to shelter more in your RESP now, then that may be better. Since you are delaying using the main advantage of an RRSP over the RESP anyway.
Like an FHSA, you could use a fat tax refund to pay down debt, top up your TFSA, or put extra into your RESP.
Lump Sum Strategies, Informal Trusts, & Corporations
It is uncommon for most people to have a big lump of money laying around with no place to go except saving for their kids. Most will build up their RESP slowly. Perhaps, add some lump sum RESP contributions to top it up when able, as they also fill their other tax-sheltered accounts as described in the preceding section. However, it does happen.
Who has $50K straight out of the birth canal anyway?
For some, it may be that a friend or relative gifts the money. That relative may be wealthy or they may have sacrificed in other ways to prioritize giving.
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.
Perhaps, you finally clean the cracks of the couch. Always a source of unexpected treasures.
Where can you park the money besides an RESP?
When optimizing lump sums contributions to an RESP, you must consider the alternatives. The best would be an accessible tax shelter, such as a TFSA, if there is unused room. If the money is a gift, then you would want to be sure that the giver is ok with you keeping it in other accounts rather than dumping it all into the RESP.
The two main non-registered options are a personal cash/taxable account or an informal trust. Both will have tax exposure. So, for the personal account, an account attributable to the lower-income spouse may be best. If the couple has similar incomes, then a joint account is more convenient. The same would apply to an informal trust.
An informal trust is an account attributable to an adult since minors cannot own an investment account. The money is held irrevocably “in trust” for the minor without a formal trust governance structure. They get ownership of the money as an adult to spend however they choose. The taxation of an informal trust is complex. Interest and dividends are taxed in the adult’s hands unless the contribution came from a student job or Canada Child Benefit. and capital gains are taxed in the minor’s hands. Second-generation interest and dividends are taxed in the minor’s hands.
My wife has an informal trust for my daughter to learn how to invest some of her student job income. I made a page with the steps and required paperwork. Again, we used Qtrade and invest with HXT and HXS. Those ETFs are free to trade at Qtrade and will hopefully only have capital gains, keeping the taxes simple. Providing this experience and the habit of investing is another powerful way to ensure your child’s financial success beyond an RESP.
Optimizing a lump sum strategy compared to a personal taxable account.
There are two big options. One is to make an RESP contribution up to a $16500 lump sum (or whatever room you have left) as soon as possible. The $16500 lump (max $14K plus $2.5K in a single year) allows you to still get the maximum CESG grant (a sure thing) as you contribute $2500/yr over 14 years and $1K in the final year. The frontload strategy lump benefits from longer tax-sheltered growth in the RESP compared to the taxable account. For that reason, frontloading beats a strategy of evenly contributing $50K spread out over the years.
The optimal lump sum contribution would be a frontloaded contribution somewhere between $16500 and $50K. In contrast to the $16.5K frontload strategy, it forgoes some of the grants to take advantage of a longer tax-sheltered growth period. Whether increased growth exceeds the lost CESG depends on a bunch of future assumptions. It is not a sure thing. Fortunately, the difference between the $16500 lump and the optimal sum is small. Except perhaps at high income tax levels. The assumptions will certainly be incorrect, but close may be good enough. I model that out in a separate post about lump sum optimization.
What if your extra cash is sitting in a private corporation account?
The money invested in a private corporation is partially taxed and still tax-exposed. So, you must weigh the tax cost of getting more out to make a personal RESP contribution against getting the grants and tax shelter of an RESP. It is also not static. If the corporation is destined to become less tax efficient, then strategically shifting money out and into a tax-sheltered account becomes more attractive.
For the child of an incorporated professional, it most commonly makes the most sense to take out just enough money to get the maximum grants. When I modeled a corporation vs RESP, that 20% risk-free return and the tax-sheltered growth made up for the incremental loss of tax deferral in the corporation. For the less common RESP vs corp situations, a lump sum strategy may be worth considering. That is because a corporation over the active-passive income limits or taking very little out can become less efficient for investing. Plus, if you are taking very little out, the personal tax bump to access the cash is much less.