Let's say you have children and a limited amount of funds to invest this RRSP
season. Should you contribute to an RESP or an RRSP? Should you sock that money
away in registered investments for your retirement or use it to save for a
child's post-secondary education, thus sparing you that expense later?
Intriguedby this mathematical dilemma, I began constructing a model that
would definitively conclude which one is best.
I soon realized there is no universal answer. As with many financial models,
there are myriad factors and assumptions involved. Let's look at the
considerations you should take into account.
The benefits of RRSPs are twofold: an immediate tax deduction resulting in a
tax refund; and secondly, tax-deferred growth until the funds are withdrawn from
the plan.
This latter benefit is also true for RESPs. Tax is deferred on contributions
until withdrawn from the plan to fund a student's fulltime post-secondary
education.
The additional benefit with RESPs, of course, is the Canada Education Savings
Grants (CESG), which equal 20% of the first $2,000 contribution per year, per
child under the age of 18 (low and middle-income families are eligible for
larger grants). In other words, if you contribute $2,000 to an RESP for 18
years, you can collect a CESG each year for a total of $7,200 after 18 years. If
annual CESGs were invested at 6% per year inside a tax-deferred RESP, after 18
years, the CESGs alone will be worth $13,000.
Since no grants are provided for RRSP contributions, does this tip the scales
in favour of RESPs? Not so fast.
The primary benefit of the RRSP is a tax refund. Assume a $2,000 annual RRSP
contribution is made each year for 18 years. A taxpayer in a 40% marginal tax
rate would receive $800 in annual tax refunds. If these refunds were invested in
a long-term, non-registered equity fund that grew by 6% per year, the value
after 18 years would be approximately $26,200. Subtracting capital gains tax of
20% on the growth would net the investor nearly $23,850.
Things get complicated when you take into account the taxation of
withdrawals; both plans are treated differently and it depends on a number of
assumptions.
With an RESP, contributions can be withdrawn tax-free, but the growth and
CESGs are taxable to the student at his or her marginal tax rate. If the student
earns income from a job while in school, that rate may be 25%. Alternatively, if
the student has no income while studying, he or she may be able to shelter all
RESP growth and CESG withdrawals through the use of personal, tuition, education
and textbook tax credits.
With an RRSP, the time horizon for compound growth is typically much longer
than a RESP. The longer the funds stay invested on a tax-deferred basis, the
greater their advantage over RESPs.
All things considered, perhaps the best plan is both plans. - Jamie Golombek,
CA, CPA, CFP, CLU, TEP is vice-president, taxation and estate planning at AIM
Trimark Investments in Toronto.
jamie.golombek@aimtrimark.com