Good Friday morning my dearest friends!
I had a close friend reach out and ask for me to write about Registered Education Savings Plans (RESPs) sometime soon. And because everyone around me is having babies these days, it only made sense to use the opportunity to become versed in RESPs.
I thought I understood RESPs before writing this piece. But the research led me all over the internet in the process, and I came away more convinced than ever that RESPs are the most lucrative investment tools available to resident Canadian families.
In short, if you have children, you need to be saving in an RESP. Even if you know your children aren’t destined for post-secondary school when they’re older, you should be investing in an RESP.
Keep reading to find out why.
Quick Thought of the Week
You really can give your children too much. This is a very modern and very first-world problem, but it’s very much a problem. Sometimes, parents focus so much on helping out their children that they forget to let their children fight their own battles.
This is particularly applicable to RESPs or big-time events like weddings and down payments. Children have to learn to save their own money. You can help them, but don’t starve your own life to save money for your children.
Those who are older and wiser have told me they were happy their parents made them live through tough times, only to receive a larger inheritance in the end.
This video doesn’t directly pertain to personal finance. But that’s fine — it pertains to business in general, and how COVID-19 has changed office life forever.
I love the Wall Street Journal these days. They seem to produce the most balanced news coverage of any news source right now.
How RESPs Are the Best Investment Tool When You Have Kids
A Registered Education Savings Plan is the most powerful way to save for your child’s future. Pretty definitive, but I mean it. RESPs are easy to setup and easy to contribute to, and you can receive an incredible 20% kick-in from the government (to a maximum of $500 per year) on your contributions each year.
Even if your child doesn’t head to university or college, I think saving and investing inside the RESP is still worthwhile.
Registered Education Savings Plan (RESP) Tech Specs
First, a bullet list of important information for clarity’s sake:
- RESPs can be setup for your children, grandchildren, nieces, nephews or even family friends. Beneficiaries (the child) have to be a Canadian resident and have a Social Insurance Number.
- RESPs can be setup as Individual RESPs for a specific beneficiary or can be setup as a Family RESP. I always recommend setting up a Family RESP as they are in nearly every way superior to Individual RESPs.
- You can contribute to an RESP for up to 31 years and the plan can remain open for 35 years (or longer if the beneficiary is disabled).
- The government matches 20% on the first $2,500 contributed each year to the RESP (leading to a maximum of $500 per year). This is the Canada Education Savings Grant (CESG).
- There is a lifetime CESG maximum per beneficiary of $7,200 and the grant is matchable until the beneficiary is 18 years old. You’ll note quickly that a maximum grant of $500 per year will finish somewhere shortly after the child’s 14th birthday. If you don’t contribute the full amount each year from birth, you can carry forward the unused CESG limit until the child turns 18 years of age.
- The rate at which CESG is paid out on your first contributions each year is dependent on your family’s net income.
Withdrawing from the RESP falls into two different scenarios. If the funds are withdrawn for education purposes, then:
- Funds are paid out to the student with proof of enrolment. Payments are comprised of the CESG amounts and investment earnings (known as Accumulated Income), and the principal amount contributed by the plan holder.
- Earnings and CESG amounts are claimed on the beneficiary’s tax return in the year of withdrawal.
- Principal withdrawal amounts are not taxed.
If the beneficiary doesn’t attend post-secondary and the funds are withdrawn for non-education purposes, you have 4 options:
- You can keep the RESP open for 36 years from the date of plan creation. This is a great option if the child needs a few years to decide their path for the future.
- You can transfer the money to a different beneficiary. This is easier if you have a Family RESP. CESG earnings and investment earnings can all be used for another beneficiary in the Family RESP plan.
- You can transfer the money to your RRSP (more below).
- You can close the RESP.
Withdrawing Funds if Your Child Goes to School
This path is easy to explain, as it’s quite common for children to go to post-secondary in their years immediately following high school. If the funds are withdrawn for education purposes, the withdrawals are made of three different portions:
- The CESG: This amount is taxable upon withdrawal.
- The investment earnings: These amounts are taxable upon withdrawal.
- The principal contributions: These amounts are not taxable upon withdrawal.
(The first two make up Accumulated Income Payments and will be reported on a T4A slip on the child’s tax return.)
So, if you read between the lines, you’ll note there is a form of income-splitting here — by contributing to the plan and earning accumulated income and having those amounts taxed in the child’s hands, it’s likely the accumulated income will be taxed in a lower tax bracket (most students have low levels of income in their post-secondary years).
To ensure the investment earnings and CESG are taxed in the lowest possible tax bracket, withdraw the earnings and CESG amounts in a year when the child does not have a summer job. Do not withdraw more than the child’s non-refundable tax credits in that tax year if you want to completely shelter the income from tax. If the child has picked up a summer job, their employment earnings will eat into the Basic Personal Amount available to shelter the income from tax. In this situation, the child should withdraw from the contribution portion of the RESP (the portion that is tax-free).
But what happens if your child doesn’t go to post-secondary? Or what if you know they’ll never want to go to school.
Well, you should still invest inside that RESP.
Withdrawing Funds if Your Child Does Not Go to School
This is where things get fun and I’ll pull some math out of my hat to prove it.
First, if you have a Family RESP, transfer any unused money to a child who is attending post-secondary school.
From here on in, my comments assume all beneficiaries of the Family RESP are not going to school.
If the child doesn’t go to post-secondary school, you have two options for the money in the RESP: You can transfer the RESP to your RRSP (to a maximum) or you can close the RESP.
Don’t close the RESP.
If you close the RESP, you’ll forfeit the CESG amounts, pay tax on the investment earnings and pay a 20% penalty on the investment earnings.
Closing the RESP is very expensive.
Instead, if the child(ren) is/are older than 21 years old and the RESP has been open for 10 years, you can withdraw the accumulated income from the RESP and transfer them to your RRSP. You can transfer up to $50,000 tax-free to your RRSP (assuming you have enough RRSP contribution room to do so), forfeit the CESG, and avoid the painful 20% penalty when you close the RESP.
This is fundamental to understand.
By opening an RESP and investing in the RESP throughout your child’s life, you will receive CESG money that is subsequently invested. Then, if your child doesn’t go to school, you can keep the investment earnings on the CESG money, just not the CESG itself.
In a way, this is like investing on margin: You’re “borrowing” the CESG money and investing it for your child’s life, only to “return” the CESG money back to the government in the end.
Here’s the math, which requires a fun future value calculation:
- Contributions of $200 per month ($166.67 principal plus $33.33 CESG) for 18 years (216 months) at 5% results in a future value of $83,808. Repay the CESG of $7,200 and withdraw your initial contributions of $36,000 ($166.67 x 12 x 18) and you’re left with $40,608 of accumulated earnings.
- You can transfer up to $50,000 to your RRSP tax-free (and pay tax on it later).
Here’s the math if you don’t include the RESP in the same savings plan:
- Contributions of $166.67 per month (remember, no CESG money) for 18 years (216 months) at 5% results in a future value of $58,202. Take out your initial contributions and you’re left with $22,202 of accumulated earnings.
That’s a really, really big difference. $18,407, in fact.
So, the lessons for today:
- Always open a Family RESP, as you may end up with more than one child even if you don’t plan on it.
- Contribute as much as you’re comfortable contributing to a maximum of $2,500 per year. To receive the maximum CESG, you do not need to maximize your contribution each year — the CESG maximum will be reached after 14 years. Spread out the difference of that 4 years and provide yourself some additional cash flow in your own life.
- Withdraw from the accumulated earnings of the RESP in a year where your child does not have a summer job or has low levels of income.
- Do not withdraw more than the Basic Personal Amount (plus tuition and the Canada Employment Amount, but that gets sticky) each year, unless the RESP has a large balance and your child does not anticipate going to college for a long time.
- If your child does not go to school, don’t fret — the accumulated earnings can be transferred to an RRSP to a maximum of $50,000, sheltering the income from immediate tax and allowing you to control the tax as you withdraw from your RRSP down the road.
Thanks again for reading this week. If you feel like being awesome, you can share this newsletter with your best friends and spread some of the love.
Have a happy and healthy week ahead.
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