Three contribution strategies for your child’s RESP
If you are expecting a child to come into your home, you may already be thinking about how you can help support the cost of their post-secondary education. The cost of schooling seems to be consistently outpacing inflation. How can your child positively afford it? How can you afford to set aside the money to provide that support?
The Value of the Registered Education Savings Plan (RESP)
Unlike the Registered Retirement Savings Plan, you do not get a tax deduction for contributing to an RESP. However, you do get the benefit of having the contributions sheltered from tax while they are in the account. In other words, while in the plan income from investments that pay interest or dividends is not taxed, nor are capital gains from investments sold at a profit.
Canada Educations Savings Grant
Parents may want to contribute to an RESP for their child but find it difficult to cut spending in other areas in order to fund this plan. An incentive the government provides to encourage this saving is the Canada Education Savings Grant (CESG). Each year the CESG provides 20% of the RESP contributions of up to $2,500. That means up to $500 per year is added to the account. If you don’t start contributing right away or miss some years during the qualifying age (up to the year the child turns 17) of the beneficiary child, you can catch up by contributing up to $5,000 in a given year, which will yield a $1,000 grant.
Low- and Middle-Income Households
If you are in a low- or middle-income family, you may find it difficult to contribute the full $2,500 each year. For such households, the government has an Additional amount of CESG available on the first $500 of contributions. If your 2021 adjusted income is $49,020 or less, an additional $100 grant may be received. If the figure is greater than $49,020 up to $98,040, then up to $50 extra may be granted.
Canada Learning Bond
Low-income families also have access to the Canada Learning Bond (CLB). This is money that the government contributes to an RESP without any personal contributions being required.
The total that the government will contribute is $500 for the first year of eligibility, followed by $100 each year the child is eligible. Eligibility continues up to and including the year the child turns 15. The maximum amount that the government will contribute is $2,000.
A Caveat: Not all Education Savings Plans are created equal
Some businesses, often known as scholarship trusts, provide group RESPs. These organizations are heavy on fees, penalties, restrictions, and rules. With group RESPs, your contributions are pooled with those of others who have beneficiary children of the same age (thus the term “group”).
Do not use these organizations. If you don’t feel confident about managing your children’s RESP, go to your bank, credit union, mutual fund company, or a robo-advisor. These may not be considered ideal for the self-directed investor who is looking for the lowest cost option, but they will give you flexibility and discretion that the group plan providers do not.
Coincidentally, as I was writing this post, I became aware of a class-action lawsuit authorized in Quebec against several group RESP providers. You can find out more here.
For the following comparison, a few assumptions need to be made. First, we will deal with only one child, born early in the year, and for whom a social insurance number has been given soon after birth. We will also assume that the family does not qualify for the Additional CESG or the CLB. Other assumptions are as follows.
The total contribution limit per child is $50,000 currently. We will assume that for each scenario, the limit will be achieved.
No beneficiary child can receive more than $7,200 in lifetime CESG, including those who are eligible for the Additional CESG. We will assume that for each scenario, the full $7,200 will be received.
Rate of Return
For the equity portion of the investments, I have followed the proportion of Canadian, US, International (Developed Markets), and Emerging Markets equities as found in the Vanguard All-Equity ETF (VEQT). FP Canada has published long-term expected returns for various assets, which I have used to calculate an expected nominal annual return of 6.58%. After the 0.25% MER, that is reduced to 6.33%.
For the fixed income portion, I have chosen an interest rate of 1.70% based on the return of a 5-year GIC available through a discount broker.
For this exercise, during the first 12 years of the child’s life, the account will be invested 100% in equities. Beginning when the beneficiary child is age 13, five years before the presumed first of four years of post-secondary education, 25% of the balance of the account will be shifted to a five-year GIC. The next year 50% of the total balance will be in GICs. The year after that 75%, and finally, it will shift to 100% GICs. At the beginning of each year of university, one-quarter of the account will mature making it available for funding education expenses.
Post-secondary education tuition and expenses are generally rising faster than the rate of inflation, which the Bank of Canada targets at 2.0%. I have therefore set 3.0% as the expected inflation for post-secondary education costs. Returns used for this illustration will be as follows:
You may be alarmed at the prospect of losing money by having little to nothing of your RESP invested in assets that have a reasonable chance of beating inflation. However, as you approach the time when you will begin spending the money, it’s simply not prudent to take the risk of losses in the stock market when you are going to spend it all in about four years.
Another reason for using real (inflation-adjusted) returns is to help you get a feel for the money that you will have saved, because the final balances you will see below represent what you can reasonably expect on average, in today’s dollars.
Strategy 1: Lump Sum Contribution
The maximum lifetime contribution allowed for the beneficiary of an RESP is $50,000. There is no rule prohibiting that $50,000 from being contributed all at once. Certainly, however, the wherewithal to do so is a limiting factor. Not everyone can simply come up with $50,000. Even so, there may be some who can do that. And for those who can, this is an example of the result:
Yes, you forgo all but $500 of the $7,200 in CESG but in exchange, you gain all those years of compounding growth without tax implications.
Strategy 2: Front-Loading Annual Contributions
If you are diligent about contributing $2,500 to the RESP from the year of the child’s birth, you will find that you run out of grant room before you run out of contribution room. You may not be able to follow the first strategy by investing $50,000 up front. You may also find it objectionable to not maximize the grant. However, you may be able to front-load your contributions, while still getting all the CESG available.
As you can see in the above table, by using this approach, you can get all the grant money and still take some advantage of the time value available by investing more money earlier on.
Strategy 3: Regular Annual Contributions
These strategies all look well and good, but probably relatively few households can set aside either $50,000 or $16,500 to begin funding their child’s RESP. If you happen to have two, three, or four children in quick succession, it can be nearly impossible – unless perhaps your parents want to contribute to their grandchildren’s educational future. The more reasonable strategy, then, is to follow the normal path and contribute $2,500 per year.
Note that this third strategy still allows you to maximize the CESG on the same timeline as the second strategy. However, if you keep the $2,500-per-year pace throughout, you will not have maximized your contributions until entering the second year of post-secondary education. This is not a bad situation, by any means. Many parents have not managed to set aside any money at all for their children’s post-secondary education, let alone maximize the available contribution room and grants.
Recap: Returns Compared
The following table compares the monetary returns across the strategies at the end of the year the beneficiary child turns 17. Note that this means Strategy 3, is short by $5,000 in terms of the accumulated contributions, but it is fair in showing how much can accumulate in the same amount of time.
Observe how different are the real versus nominal returns. I think there are at least two messages here. First, the effect of compounding on investment returns is significant. Second, inflation can have a powerful impact on the value of those returns. These messages apply beyond RESPs, of course.
This is the 103rd blog post for Russ Writes.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.