Preface: Part 3 of this Guide is WRONG
I’ll leave it up as a memorial to the facts that (1) I can be incorrect and, as I say in the article, (2) you should always seek professional advice. You can only earn a maximum of a $1,000 CESG (Canada Education Savings Grant) in a given year. That’s stupid, for the reasons mentioned in Part 3. Adjust your plans accordingly, although it’s likely impossible to predict your child’s academic path when they’re aged 10. There’s other good advice in Parts 1, 2, and 4. Enjoy!
RESP Guide, Part 1: do Registered Education Savings Plans (RESPs) help or hurt kids?
Before I tell you how to effectively use the subsidized savings vehicles known as RESPs (and in a way that nobody recommends, because they all want to take your money), I should preface my brief RESP Guide with a clarification:
I don’t believe in RESPs.
No parent owes his or her child a free ride through university. My parents didn’t pay for any of my $23,000+ in tuition and fees. They didn’t even buy my books or pay my rent. They did buy two laptops as gifts (not at the same time) and that’s about it. They could have easily afforded much more. But I didn’t expect free money and I’m not complaining. Far from it.
Further, a free ride in university can sabotage a student’s success. Having to pay one’s own way instills independence. I was much more motivated. Sure, I partied once a week, but I didn’t drink every night. If I hadn’t gotten academic scholarships (over $30,000 worth), I would have probably gone into debt. I worked during the summers. Instead of being infantilized by reliance on my parents, I became an adult.
If you’re not faced with limited resources, you won’t make economically-sound decisions. I went to Trent University, largely, because my grandparents lived in the city and I could stay with them. If my parents had given me a blank cheque, I would have been more likely to pursue my love for writing with a B.A. in English or something equally frivolous. I might have gone to school in BC. Or maybe I would have taken a year off. Scarcity forces a person to think rationally. If you’re not faced with limited resources, you’ll do dumber things. Why do you think the federal government is always so incompetent?
RESP Guide, Part 2: can you afford to contribute to an RESP?
OK, so my bias has been clearly stated. You still want to pay for Junior’s formal education.
Should you contribute? My answer is decisive: only if you can afford it (and you probably can’t).
- Do you have consumer debt? If so, you can’t afford RESP contributions. Consumer debts include anything other than a mortgage. HELOC? Consumer debt. Car loan? Consumer debt. Side note: it is stunning that there are people with student loans who are saving for theirs kids’ educations. That’s hardcore money-stupidity. Quit reading this article and work on paying off your debt.
- Do you have a sufficient emergency fund? A sufficient emergency fund is equal to your net income for six months. It is fully liquid, i.e. 100% cash. It’s fully segregated from any other savings (e.g. separate from retirement savings and any planned spending accounts).
- Do you have a fully funded retirement account? In other words: do you and your partner/spouse have ZERO contribution room remaining for your RRSPs and TFSAs? If you have any contribution room remaining then, no, you do not have a fully-funded retirement account. It is an opiate to some people to plan for their kids’ futures – it allows them to ignore the critical need to plan for their own futures. If you don’t have a fully funded retirement account and you’re researching how to save in RESPs, you are one of these delusional persons. Stop reading this article.
- Are you on track to have your mortgage fully repaid by the time your oldest child turns 15? If not, then no, you can’t afford it. Focus on getting debt free! When you’re mortgage free, you’ll have a lot more flexibility to help your kids.
RESP Guide, Part 3: How should you, the parental rose among thorns, contribute to an RESP?
Ask yourself a question:
What’s the biggest unique benefit of an RESP?
If you think it’s tax treatment, you’re wrong. RRSPs allow money to grow tax free just like an RESP. The difference is that an RRSP gives you a tax break up-front. An RESP doesn’t.
When you withdraw money from a TFSA, it’s tax-free. Money withdrawn from an RESP, on the other hand, is still taxable. When a student receives RESP money for an eligible education expense, it’s taxable in the hands of the student. “But Joe! Students are poor so they won’t pay taxes!” You’re probably right. But RESP withdrawals can adversely impact the student’s ability to get needs-based scholarships or (as a last resort) government loans.
And think about this: if a child saved money for education in his own name, why would it need to be in a tax-sheltered account?? If he simply saved his RESP money in a taxable high-interest savings account he probably wouldn’t pay taxes because his income is negligible. Then he could just use the RESP strategy that I lay out later in this article.
The financial industry’s labeling of RESPs as “tax-advantaged” or “tax-sheltered” is one of the grandest scams in Canadian personal finance. And that’s coming from the same financial services industry that brought us the Canadian housing bubble.
The biggest benefit of an RESP is the Canada Education Savings Grant (CESG). On every dollar you put into an RESP, the government adds twenty cents. The maximum CESG is $7,200 per child (I realize there are certain bonuses for parents with lower incomes. I don’t consider these “income-tested” grants in my analysis; all the more reason that you should always speak to a financial professional and never take my advice). The $7,200 CESG maximum means that you stop receiving grant money after you’ve contributed $36,000 per child.
The CESG is a 20% rate of return! Crazy! But it may not be as amazing as it sounds. It’s important to note that the one-year return on your money is only 20% if you deposit the capital, receive the 20% CESG, and remove the money at the end of the first year.
Let’s say you invest $1000 into an RESP. You put it in an RESP savings account that pays 2% a year (good luck finding that). Your first year return including the CESG would be a whopping $224, or 22.4%! Inconceivable!
But let’s say your kid doesn’t go to university at the end of the RESP’s first year. He waits another year. In the second year, you’d only earn $24.48 on the total invested capital (the original capital + the CESG + the first year’s interest). Suddenly, your annual return is only 12.42%. Not exactly impressive. Add a third year? 9.1%. It continues to decline in this fashion. The CESG subsidy means your investment returns become less impressive as time goes by.
Now let’s imagine that you use an RESP the way that you’ve been told to by Canada’s banksters. You run down to your branch and open an RESP on the day your child is born. You put the money in an actively-managed fund. The fund syphons off a solid 2 or 3% of Junior’s returns every year for their Management Expense Ratio (MER). Despite egregious management fees paid to “financial Gandolphs” (as Adina calls them — you should really read the article she wrote yesterday), these clowns can’t even beat the market. Some years you might earn 5%. Other years you might earn nothing. And let’s hope you didn’t start saving for Junior’s education in the year 2008, or Junior is headed for Trent.
Hence the CESG is the biggest RESP benefit because it’s a large risk-free return. This benefit is significantly eroded by time and risk.
(BTW, I was kidding, Trent is a good school).
If you invest in an RESP early (and probably before you’ve met all of the criteria in Part 2), you’re eroding the benefit of the risk-free, instant 20% CESG return. To outweigh the corrosive effect of time, you’d need to get a very high rate of return. To get a high rate of return, you’d need to take bigger risks – especially in today’s markets. Bet big with your retirement funds when you’re age 28. Don’t gamble with your 10-year-old’s educational savings.
OK, that all makes sense. Now ask yourself a second question:
What’s the biggest risk of saving in an RESP?
It’s the risk that your kid won’t go to post-secondary or goes to university and drops out. Then you stand to lose all of the CESG money and possibly more (I won’t get into penalties here; suffice it to say they suck), rendering the whole savings endeavor pointless.
Getting the most value out of an RESP now becomes a simple question: how can a parent optimize the risk-benefit relationship?
Don’t use RESPs the way you’ve been told. Save late, not early.
Maximize the benefit by getting all of the free grant money you can. And do it as late as you can.
Minimize the risk by only saving when you’re reasonably confident your child will actually attend post-secondary — then save the money over the least amount of time possible while minimizing investment risk. Remember: we’re after the 20% risk-free subsidy, not capital gains or dividends or 1% savings account interest.
Here’s an example of how you might go about maximizing the benefit while minimizing the risk of an RESP:
When your daughter turns 15, assess her first year in highschool. Did she get good grades? Is she hanging out with the right crowd? If so, start saving $1,500 a month specifically earmarked for her education. Can’t save $1,500 a month? Well, you probably didn’t answer the questions in Part 2 honestly. Or you made the mistake of having kids within 2 years of each other. Adapt this plan as best you can.
The day that your daughter turns 17, you should have $36,000 saved up (more including interest, but only earmark $36,000 for the RESP). Remember? $36,000 is the magic number required to get the maximum grant of $7,200! But don’t put it in the RESP yet. Wait to deposit it until the last possible month.
If she messes up royally, don’t put the money in her RESP. If you do, you’ll probably only live to regret it. Sure, she doesn’t get $7,200 in free money. At least you’ll still have your $36 grand. Tough love at its finest.
If she’s a thriving young adult, deposit the money and you’ll enjoy an instant, risk-free return of 20%. Well, she’ll enjoy it. Six months later she goes to university, and you just beat the system.
Note that there are a bunch of ways to adapt my idea to your specific situation. As I alluded in my example, it’s best to space kids apart by at least two years (I know, I know. Kids aren’t clockwork. Tell me about it, I dare you). Perhaps you could match your child’s own educational savings dollar-for-dollar. Some programs are inexpensive or short and wouldn’t require a $43,200 RESP for a full ride.
Best advice of all: get your kid into an apprenticeship during high school (make sure it’s a useful trade) and she probably won’t even need your money for college. As a graduation present, give her money for a job search trip to Northern Alberta.
RESP Guide, Part 4: Are you considering a Group RESP plan?
Don’t. That is all.