Saturday, 20 August 2011

Education Savings Options: RESP, TFSA or RRSP?

Back in 2007 I compared the RESP and the RRSP as investment savings options for funding higher education, excluding the TFSA since it did not yet exist. The conclusion at the time was that the first $2500 of savings should go into an RESP to take advantage of the free money (courtesy of other taxpayers) available from the federal government in the form of the Canada Education Savings Grant. The $500 annual CESG (20% of contributions up to $500 per year and $7200 maximum lifetime - more details here from made all the difference.

It's time to revisit the question. First, the TFSA now exists. Second, an anonymous comment this past July on the original post suggested the RRSP might be better if one takes into account the possibility that the student can transfer up to $5000 in annual tuition deduction during the time of eventual study, which gives the parent a 15% tax credit (i.e. $750) on the tuition transferred. Excellent question! With interesting results too.

I've built a downloadable spreadsheet (look for the download link on the right hand side of the web page once the spreadsheet opens up as a Google doc in your browser) for readers to play with beyond what I have already done.

Conditions Applied to My Analysis:
  • Parent Must Have Enough RRSP Contribution Room - The whole analysis presumes you can put in $2500 per year new money plus up to $2100 reinvesting the tax refund each contribution generates, plus the reinvested refund on the reinvested refund, plus the reinvested refund on the reinvested refund on the reinvested refund etc ... (remember that child's song, there's a hole in the bottom of the sea? this is the tax refund version of it); that's why the RRSP part of the spreadsheet extends way out to the right. At the top Ontario marginal tax rate of 46.41% (see's tables for personal tax rates in each Province, which readers can use to check what happens in their own bailiwick) that means needing another $2100 or so of extra annual contribution room. Doing this gives the RRSP option its most favourable conditions.
  • Only $2500 in Annual Contributions - This condition is to give the RESP its most favourable conditions, namely that it gets the most free CESG money, so that each contribution buck is getting the most bang.
  • Child Must Not Have Enough Income to be Liable for Taxes during Higher Education Years - As I noted in the original post, the RESP's advantage disappears if the student has to pay taxes, even at the lowest tax bracket (see the Student_Taxable tab in the spreadsheet).

Results: (the summary numbers for the discussion below are in the Results tab and the calculation table with inputs you can use to plug in your own numbers is in the RESP_RRSP_TFSA tab; other tabs contain the calculation tables from the original post)

1) RESP is (Almost) Always Best ... if the Child Takes Post-Secondary Higher Education - No matter what the parent's tax rate, the RESP comes out ahead after tax, as shown by the green numbers. The only circumstance when it does not is when, as shown by the red numbers in the Results tab, the parent's tax rate at time of withdrawal is at least three tax brackets lower than at time of contribution - e.g. taxable income goes down from $100k to $70k as in retirement - and the investments earn a low (2%) to medium (5%) annual return. In this latter case, the RRSP wins, but not by much.

2) TFSA Wins if the Child Does Not Attend Higher Education and Parent's Tax Rate Stays the Same - The green numbers under TFSA show that no matter what tax rate the parent is in and regardless of investment returns, the TFSA does better, but not by a lot, than both the RESP and the RRSP.

3) RRSP Wins if Child Does Not Attend Higher Education and Parent's Tax Rate Drops at Withdrawal - The green numbers in the RRSP column show that the RRSP does better and better the more the parent's tax bracket drops between the date of contribution and withdrawal. The higher the investment return, the bigger the effect. When it is three brackets lower and there are high (8%) returns, the net difference is $25,000 more than the RESP and $15,000 more than the TFSA.

Bottom Line:
  • if you are confident that your child will go to college/university before you retire, put that first $2500 into the RESP; if you have several kids, the chances should be higher that at least one of them will go on.
  • if you really are not sure your child will go on to higher education , then the RRSP is the better hedging option. The TFSA's advantage when the child does go on isn't big enough to offset the TFSA's lower results compared the RRSP when the child does not go on. Also in the RRPS's favour is that the RRSP's disadvantage compared even to the RESP when the child goes on is much less when investment returns are low and you are in the lower tax brackets.
  • if you believe that your income will drop two or more tax brackets by the time the higher education decision will need to be taken, the RRSP looks better even than the RESP. When there is no higher education the RRSP is always superior to the RESP and even when there is higher education, at two brackets lower you are ahead except at high investment returns. If your investments within the education account are cautious and low risk, low to medium returns are what you will get.

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