Paying for your child's education will help him or her get a head-start on life, and remove the burden of having to pay for their own education via working and/or student loans.
The government of Canada has a special investment vehicle called a Registered Education Savings Plan (RESP) that combines tax deferrals with eligibility for a wide variety of government grants. While the contribution limits are easy to understand, you need to be careful with timing the contributions in order to get the maximum grant money. Similarly, while there are no withdrawal limits, there are guidelines to limit the amount you pay in taxes. Read on for details...
Beneficiary and Subscriber
There are two key terms that will be used throughout this article, beneficiary, and subscriber. A beneficiary is the individual for whom the money is intended. In order to be named a beneficiary, the individual must be under 21, have a Social Insurance Number, and be a resident of Canada.
The subscriber is the person making the contributions into the plan. For an "individual plan", there are no requirements on the relationship between the subscriber and the (one) beneficiary. A "family plan" RESP allows for the money to be pooled and transferred between beneficiaries, so all subscribers must be related by blood or adoption to all beneficiaries.
Contributions and Taxes
Since 2007 the lifetime contribution limit of an RESP has been set at $50,000. This amount is per-beneficiary, so if there is more than one RESP open in one beneficiary's name, the subscribers need to coordinate so that they don't exceed this amount. There is no per-year maximum, so it is possible to open an RESP and make an initial contribution equal to the lifetime contribution limit.
Contributions are not tax-deductible, so an RESP behaves like a TFSA in that respect. The money in an RESP grows tax-deferred until it is withdrawn.
Government Grants
The greatest advantage of an RESP compared to a TFSA is that there are government grants available for an RESP. There are three kinds of government grants that may apply:
- Canada Education Savings Grant (CESG): government matching program of 20% of contributions to an annual maximum, explained in detail below;
- Canada Learning Bond (CLB): a government grant of $500 + $100/year for up to 15 years given to low-income families that qualify for the National Child Benefit Supplement (NCBS), which requires a family income below the 22% tax bracket ($43,561 for 2103);
- Provincial grants for Alberta (ACES), Quebec (QESI), and Saskatchewan (SAGES) as of time of writing.
The CESG is the most common and most complicated of the three kinds of government grants, so it will be explained in detail. For every calendar year, $500 of CESG contribution room is added to a lifetime limit of $7,200 (reached 14 calendar years after the child was born). The maximum grant that can be paid out in a given year is $1,000.
For example, if a child was born 10 calendar years ago, there are 11 calendar years, or $5,500 of accumulated CESG contribution room. A contribution of $10,000 is made, that would be matched at 20%, but the CESG annual maximum of $1,000 would be reached first. Following this contribution, there would be $11,000 in the account (ignoring the CLB or provincial grants) and the accumulated CESG contribution room would be reduced to $4,500. The following year, another $500 is added to the grant room, bringing the total to $5,000.
The consequence of the above is that to get the full $7,200 CESG grant, you need to spread out your contributions so you don't hit the $50,000 lifetime limit before all the matching CESG is paid out. The $50,000 lifetime limit is the total contributions by all subscribers for one beneficiary, and does not include any government grants or interest. The optimal contribution to get the grant as fast as possible is to contribute $2,500 per year in each of years 0 (the year the child is born) through 13 and $1000 in the year the child turns 14, for a total of $36,000. It doesn't matter when the remaining $14,000 to reach the lifetime limit is contributed.
There are two additional rules for the CESG that may apply to some people. The first is that there is an "Additional CESG" for those with low incomes. If the family income is below the 22% tax bracket ($43,561 for 2013), the grant will match 40% of the first $500 of contributions in the calendar year. If the family income is in the 22% tax bracket (between $43,561 and $87,123 for 2013), the grant will match 30% of the first $500 in contributions. In either case, the lifetime maximum CESG is still $7,200, but it is possible to get to this maximum CESG contribution faster for families with low incomes. Assuming the family is below the 22% tax bracket, it's possible to obtain all the grant money by the year the child turns 11.
The second rule specific to the CESG is meant to discourage using the RESP as a short term grant-exploiting savings vehicle. To get any CESG in the years the beneficiary is 16 or 17, one of these two conditions must be met: 1) at least $2,000 has been contributed before the year the beneficiary turned 16 OR 2) at least $100 has been contributed in any 4 years before the year the beneficiary turned 16.
Withdrawing from an RESP
To make a withdrawal, the beneficiary must be attending a "qualifying education program". There are a few other cases where the money can be withdrawn or transferred (e.g. when the beneficiary doesn't want to go to school), but they are beyond the scope of this article.
The money in a self-directed RESP, that is one where you have control over how it is invested, is pooled together without labelling which dollars came from where. However, when it comes to withdraw the money, it is divided into 3 pools that are treated differently:
- contributions: this is the after-tax money that went in to the accounts;
- grants: this is the money that came from the government, and if the beneficiary doesn't attend a qualifying education program, all of it must be returned;
- interest: this the interest earned on both the contributions and the grants.
Contributions can be withdrawn, called a "refund of contributions", and are tax-free. Both grants and interest are withdrawn as "educational assistance payments" (EAP), and are taxable in the hands of the beneficiary. Because students generally have little taxable income, it's likely that there will be little or no tax on the EAPs, but it still needs to be reported as income. When making a withdrawal, you need to tell the promoter (i.e. the company holding the money) whether it's a refund of contributions or an EAP.
Be Wary of High Fees with RESPs
A type of particular products that are heavily advertised for RESPs are so-called "Group RESPs". These funds charge an upfront sales commission based on units (shares). As a result, for some funds, you can expect to lose approximately 5% of any contributions in fees for what is essentially a front-end load mutual fund.
The other disadvantage of Group RESPs is that they generally keep your money separate from the interest earned, so if your child decides not to pursue post-secondary education, both your interest and the interest on the government grants is forfeited. However, one advantage these funds do offer is that if your child does attend a "qualifying education program" (caution: some group RESPs have their own, more narrow, definition of what this is) then you get any attrition money from the other subscribers who dropped out. This attrition money is the interest on the contributions and government grants of those who dropped out of the plan.
Other than Group RESPs, the second most-popular choice for an RESP vehicle is to open an account at your local financial institution. Unfortunately, RESPs aren't as popular as TFSAs or RRSPs, so banks may not be familiar with the intricate contribution and withdrawal rules of the RESP. They will generally offer to put you in a "Target Date Education Fund", which is often an adequate choice, but it usually entails a high management expense ratio (MER) of over 2%. Making uniform contributions over the course of 18 years you could expect to lose about 18% of your investment to this high MER fee.
At CJ Capital, we can help you evaluate an allocation to funds that will perform similarly to a "Target Date Education Fund", but with a significantly reduced MER. As an example of potential savings, assuming an individual is able to reduce the MER by 2/3rds, from 2% down to 0.67%, and contributes $2,500 per year for 18 years, the savings on the MER fees could be nearly $10,000!