RESPs: How to get the biggest bang for your buck
It seems like everywhere you look these days, there's a back-to-school sale. Frankly, I'm somewhat skeptical as to whether returning students actually need a new home-theatre system to succeed, but electronics retailer Best Buy, in an online ad, claims that "Studies show great sound improves GPA."
What could help even more, in my opinion, is a well-funded education savings plan, ideally, in the form of a Registered Education Savings Plan. While RESPs have been around for many years, and really took off in 1998 with the introduction of the matching 20% Canada Education Savings Grants (CESGs), my experience is that parents are not using them in the most strategic or optimal manner possible.
Here's a quick overview of the basic rules and then we'll run through a couple of optimization strategies.
The RESP is a tax-deferred savings plan that helps an individual, typically a parent, save for a child's post-secondary education. Similar to other registered plans, the RESP is in essence a wrapper in which you can hold various eligible investment products, such as GICs, mutual funds and even individual stocks and bonds. Unlike RRSPs, contributions to an RESP are not tax-deductible nor are they taxable when withdrawn.
The main benefit of the RESP is the ability to have all earnings (capital gains, dividends and interest) on the investments inside the RESP accumulate tax-free until withdrawn. When the funds are paid out, they are included in the student's income but presumably the child will be in a low- or zero-tax bracket, on account of the various tax credits available to them (including, most commonly, the basic personal amount and tuition, education and textbook amounts) that little, if any, tax will ever be paid on the earnings when withdrawn.
The other benefit is the CESG, equal to 20% of the annual contributions, to a maximum of $500 (or $1,000 if there is unused grant room from previous years). The maximum CESG entitlement is capped at $7,200 per child.
When funding an RESP, the first missed opportunity is that parents often only start thinking about contributing to their kids' RESPs several years after their children are born. But contributing to an RESP as soon as possible can reap significant financial rewards down the road.
For example, take Alan, who starts saving for his daughter Amy's education the year she is born. If he contributes the $2,500 maximum amount needed each year to maximize the CESGs until he hits $36,000 of contributions in the year Amy turns 14, he will have accumulated nearly $61,000 in Amy's RESP by the time she is 18, assuming a 3% rate of return.
Contrast this with Zoe, who only starts saving for her son Zack's education when he turns 10 by contributing $1,000 in that year and then $5,000 each year from age 11 to 17 to catch up on all prior years' CESGs. By the time Zack is 18, assuming the same 3% rate of return, Zack's RESP would only be worth $49,000, despite Zoe having contributed the same $36,000 that Alan contributed.
Finally, for those parents who can afford to do so, consider maximizing the tax-deferred (or, most probably, tax-free) compounding by contributing beyond the annual amounts needed to maximize the CESGs. This can be done by making an additional lump sum contribution of $14,000, bringing the total amount contributed up to the lifetime maximum of $50,000 per child.