Friday, 23 February 2007

RESP vs RRSP - The Best Approach is Clear



Update 2008...
Last year I compared a choice that parents often face - whether to contribute to an RESP for a child's education or to an RRSP - and concluded that the RESP was the better option. The maximum CESG (Canada Education Savings Grant) has gone up from $400 to $500 per year. That means the RESP contribution required to obtain the maximum amount of grant money from the federal government goes up to $2500, since the CESG is calculated as 20% of the contribution up to the maximum grant. The good news for 2007 and beyond is that last year's conclusion is the same - that the RESP is better. If you can contribute to both your RRSP and an RESP then by all means do so but if you have limited funds the RESP is the way to go.

Here is how and why that is so. Unlike this analysis by Jamie Golombek in the Financial Post that concludes "All things considered, perhaps the best plan is both plans.", and this Financial Post report of February 4, 2008, my own analysis shows that up to $2500 the RESP is a better choice.

First, I assume that a parent does not care whether he/she benefits or the child does and that the maximization of family wealth down the road after taxes is what counts. I have used similar assumptions about rates of return as Mr. Golombek just for convenience but my analysis is different to simplify and to clarify i.e. to compare only apples with oranges and not throw in lemons as well. Referring to the spreadsheet table ...in contributing $2500 to an RRSP, a taxpayer will receive a tax refund, which I assume to be calculated at the next to top Ontario marginal tax rate of 43.41%. That refund is assumed to be added back into the RRSP and the tax refund on the tax refund is also assumed to be reinvested. I've extended that chain of reinvesting the refunds for five years, until the amount gets very small (under $17 by year 5). Unlike Mr. Golombek I don't assume that the RRSP tax refund will be reinvested outside the RRSP in a some stock that produces capital gains. That element is the lemons I mentioned above. The reinvestment assumption enhances the RRSP option since the compounding occurs tax-exempt. The higher marginal tax rate also enhances the RRSP option since that will produce a bigger refund to invest at the beginning and a lower tax imposed upon withdrawal. For the RESP contributor, there is no tax refund to reinvest, only the $500 CESG grant to add to the initial investment amount.

I assume that the investments both earn 6% compounded for 18 years, which is the length of time Mr. Golombek sensibly uses since that is a normal maximum duration of contributions before a child enters post-secondary education. How long the compounding period lasts doesn't matter at all to the conclusion however, it just increases or decreases the advantage of the better choice. The 6% return is used for inside both the RESP and the RRSP, a cautious low number, indicating some sort of fixed income plus conservative equity investment. That rate doesn't matter either if it is the same for both.

Another thing (perhaps?) neglected by Mr. Golombek is that only the income from the RESP is taxable; contributions can be withdrawn tax free by the parent, the CRA logic being that the parent had already paid tax on them way back at the beginning. My last assumption (also not discussed by Mr. Golombek) is that the parent's tax rate is less when the RRSP money is withdrawn after 18 years since by then they will hopefully be retired. Whether or not the money would actually be withdrawn, the fact that there is a tax liability for funds within an RRSP needs to be taken into account. The lower withdrawal tax rate favours the RRSP option as well but alas, it is not enough! The only combination that makes the RRSP better than the RESP is when the parent's tax rate at time of contribution is very high and the rate at time of withdrawal is very low, e.g. the highest marginal rate of 46.41% (taxable income over $123,000) with the rate five brackets lower of 31.15% (taxable income of $37,885 to $63,428). How likely is that to happen?

Of course, if the primary objective is to save for a child's education then the RESP is the vehicle of choice. Using an RRSP to save, for 18 years in my example, would probably mean a much lower net return since the advantage of a lower tax rate at time of withdrawal, one of the essential benefits of RRSP investing, would be lost if the parent was in the peak of earning years and not retired. It might even be that the tax rate would be higher at withdrawal if the parent advanced to better pay in is/her career.

With both RESPs and RRSPs benefiting from tax-free compounding while a plan is in existence, the combined effect of income splitting with the child, who is highly likely to have little or no income tax to pay while in higher education, along with the CESG, make the RESP a better option by $55. BUT, the RESP advantage disappears for contributions over $2500. I haven't shown that table but remove the $500 CESG and redo the arithmetic to see it. Change the withdrawal tax rate up one bracket to 32.98% and the RESP is now ahead by $281. The RESP advantage also disappears when the student earns a lot and has to pay taxes, as in scenario 2, where the RRSP option is $1221 ahead after 18 years.

The example given in the Feb.4th FP article of putting $5000 into the RRSP and then putting the tax refund into the RESP produces less total wealth (RESP+RRSP value) after 18 years, considering the tax liability of the RRSP, than putting the first $2500 into the RESP and the remaining amount of $2500 into the RRSP - by $394.47 using the above base assumptions. In addition, whereas the RESP-first option produces an almost equal amount in each of the RESP and the RRSP, the FP way results in almost $3,000 less in the RESP. The differentiator is that the FP does not take advantage of the maximum CESG contribution.

Of course, there is a risk that children may not eventually attend high education. The rules do allow up to $50,000 to be transferred into the parent's RRSP in that case, providing there is contribution room. The CESG would be reclaimed by the government so that would be lost. The RESP would be less attractive in that case. The higher the level of education of the parents, the higher the chances of the children attending post-secondary education according to this Federal Government study. The same study says that in 2003, only 18% of families with children under 18 had an RESP. That's a shame since the higher education participation rate is higher than 18% so the CESG/RESP combination is thus much under-utilized.

In summary, to maximize family wealth, put the first $2500 into the RESP. After that, it goes into the RRSP.

Oh, and make sure the financial institution administering the RESP actually submits the form to the government to collect the all-important CESG; it happened more than once that my financial institution forgot to do so and I had to remind them.

6 comments:

byno said...

Thanks for the great analysis! You just made my day. I have often struggled with the decision on whether to invest in our RESP or RRSP. Since day one we have put exactly $2000 a year to each of our kids and then anything extra has gone into RRSP's.

Now I know that I am doing exactly what I should be doing. Thanks so much! :)

Investoid said...

Very good article. I appreciate your detailed analysis and assumptions.

Anonymous said...

Isn't tuition tax deductible for parents paying their child's tuition? And if so, wouldn't that mean that the RRSP is the better option as the withdrawals would effectively be tax neutral?

CanadianInvestor said...

Hi Anon, Good question! It 's nice to see people reading old postings. Yes, tuition is partially deductible by a parent. The student may transfer up to $5000 per year that the student him/herself does not need to reduce their own taxes to zero. The student must apply tuition to him or herself first, no matter who paid. Then the parent gets claim up to the $5000 on his / her own form and gets a 15% (only) tax credit, which effectively means not being able to claim any more tax back. For rules, see Taxtips.ca here - http://www.taxtips.ca/filing/students/transfercarryforward.htm and the CRA page here - http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/ncm-tx/rtrn/cmpltng/ddctns/lns300-350/323/crry-frwrd-eng.html

The net effect of the tax credit on $5k if all of it were available and used for every year of withdrawals from an RRSP would be to raise the breakeven between RRSP and RESP a couple of tax brackets. That leaves aside such issues as the loss of RRSP contribution room for the parent.

Anonymous said...

Thanks for your reply and the clarification. I've put my analysis here for your consideration.

http://dl.dropbox.com/u/16192712/Education%20Savings.htm

I believe that for our situation (both parents have defined pension plans and max contribution room) it makes most sense to use the RRSP.

Reasons;
- Lower personal investment
- Higher future value
- All of the investment remains ours, providing flexibility if children do not go to school (no CESG to repay, time control over taxable withdraws vs forced collapsing of RESP)

What are you thoughts?

CanadianInvestor said...

Anon, am following through your idea and will post a whole new analysis of this tactic shortly. One thing I am changing from your spreadsheet is to make the initial investor net after-tax deposit the same at $2500 per year.

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