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 TaxTips.ca) 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 TaxTips.ca'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.
  

RESP: Maximizing Withdrawal Benefits

You've had an RESP for long time, you've made lots of contributions, got Canada Education Savings Grants (CESG) and perhaps an Alberta Centennial Education Savings Plan Grant if you live in Alberta. You have a family plan with two or three kids as beneficiaries. The kids are young adults and it is now time to take the money out. Here are some thoughts on getting the maximum benefit from the RESP.

Note the best source of information - the Human Resources and Skills Development Canada Promoter Tools. HRSDC is the horse's mouth and the information is detailed and precise with helpful tables and examples. Skip their consumer info pages if you really want to know how things work. The Canada Revenue Agency has a good FAQ on RESPs. Other government sources like CanLearn, Financial Consumer Agency of Canada and Service Canada serve up really basic baby pablum type info which in some cases is misleadingly general. I would also warn people off CRA's IC93-3R, as the copy I found on the CRA website is dated 2004 and is out of date. CRA's RC4092 is better.

1) Wait till the child/beneficiary is in a qualifying educational program before removing any funds. You (the subscriber) are allowed to take out your contributions (actually, anyone's contributions since, as far as HRSDC and plan promoters are concerned, the subscriber becomes the owner of the contributions, not the beneficiaries, nor the aunt, uncle or grandparents who may have deposited money). But taking money out early means you will have HRDSC asking for the corresponding CESG back.

The list of qualifying institutions is vast, not just university or college, so there is no excuse. The minimum length for a program is three weeks. Send them to the Kanine Klipping All Breed Grooming School in Saskatoon (check the list under K). The travel expenses can count as education expenses since there isn't anything more detailed about the requirements for expenses than to further post-secondary education.

2) Remove the CESG (and Alberta grant, if applicable) once the student is enrolled in a program by requesting the Promoter (discount broker if an self-directed RESP; complete list is here at HRSDC) to make an Education Assistance Payment (EAP). Once the student is enrolled, i.e. eligible for the EAP, you can also ask for contributions back, even if you have not requested an EAP. Your contributions always come back tax-free no matter who they go to, you, the student or anyone else (makes sense since you paid tax on that money before contributing and did not get a tax deduction or credit when making the RESP contribution). When the RESP has made money, some of the EAP will consist of CESG and some from interest, dividends or capital gains but the source of the return is lost and all the EAP is considered other income and taxed in the hands of the student at the student's marginal rate .... which should be minimal or zero due to low income and lots of deductions. It's probably best in most cases to remove only what is needed each year of a study program to even out the student's taxable income flow and allow the remainder to continue growing tax-protected.

You do not get to choose the proportions of CESG and profit removed in an EAP. You state a total desired withdrawal and there is a mandated formula that pro-rates the amounts. There is no withholding tax on withdrawal, unlike on RRSPs.

An EAP with earnings passed to a no-tax child achieves income splitting, a big tax benefit as the profits that you could have made in a taxable plan would have been taxed at your much higher marginal rates.

After the first 13 weeks of study, during which time only $5000 in EAP can be paid to a full-time student, the only limit to EAP without hassle is the informal $20,000 (2008 dollars that will be inflation-indexed) limit that CRA has told RESP providers it will not question in paragraph 6(i) of its RESP FAQ. Part-time studies are a bit more complicated in restricting an EAP to $2500 in each 13 week period preceding the EAP (see example worked through on this HRSDC page). There is an option to obtain more as an exception by having your RESP provider write to the folks at HRSDC. All the EAPs are only supposed to be paid for legitimate education expenses but receipts and strict lists of acceptable vs unacceptable expenses are not provided so I would guess most RESP providers will be quite cooperative when you ask for an EAP amount.

3) If the child doesn't go on to any sort of post-secondary studies, transfer the earnings of the plan to your RRSP. Up to $50,000 of earnings can be transferred if there is RRSP contribution room and as long as your are under 71, when one can no longer make any contribution to an RRSP. A transfer to an RRSP is better than taking earnings as an Accumulated Income Payment (AIP) into your own income since you will pay tax at your normal rate plus a 20% surcharge. AIP does not include your contributions, which you can withdraw without tax. It is also better than another possibility, which is to give the AIP money to an educational institution, since such a gift does not even qualify for a charitable donation receipt.

4) Include all your children in a family plan - and you can add them later if they are under 21 - so that the CESG can be shared amongst the siblings. CESG paid into a family plan RESP may be used by any beneficiary of the RESP to a maximum of $7,200 per beneficiary. It doesn't have to be the same child under whose name the CESG was obtained. Nor does the CESG or the EAP have to be shared equally amongst the beneficiaries, which can be a boon if only one child goes on to further studies. How you maintain fairness in the family is your personal matter unaffected by this flexibility in the rules.

Plan providers are supposed to keep accounts of contributions and track how much CESG is paid out to each beneficiary. My provider insists that it will prevent an EAP that would try to take too much CESG out for a particular beneficiary in a family plan - e.g. if two beneficiaries had $10,000 in CESG between them, only $7200 could be taken in EAPs by either one. But I would double check and track the CESG for each child just to be sure because if an over-wthdrawal happens, HRSDC will ask for the extra CESG back from the beneficiary.

An interesting aside is that only blood relatives can share a family plan. Blood relatives includes parents, brothers and sisters, children, grandchildren and great grand-children and onwards, but not nieces, nephews, aunts, uncles, cousins. A grandparent can start a plan too, so your parents could start a plan where CESG is shared amongst your children and their cousins. The sharing only applies to the basic CESG, not the extra supplement of $50 or $100 per child given to lower income earners (see this HRSDC page). If it is not a sibling-only plan, the additional CESG is not given.

5) If the RESP has a loss then don't close it even if the children have finished their education and all the CESG has been used up with EAP. There is no hurry to close the RESP since a plan now may stay open for 35 years. That gives time to recoup any investing losses tax-free! Here's how this works. First, a loss exists when "the fair market value is less than the total of assisted contributions, unassisted contributions, the CLB, the CESG, and the Alberta Grant accounts in the RESP." (on this HRSDC page) There is no need for messy accounting on interest or dividends received from investments being considered as earnings, it is simply whether the market value is less than "book value". When one also notes that contributions can be made for a beneficiary up to his/her age 30 and up to 31 years after plan opening, that can even allow further contributions to be made. Such contributions can gain profit tax-free up to the point all the losses have been recouped, at which point everything can be withdrawn tax-free as a return of contribution. The rules allows you to make up your investing misfortune (or stupidity) tax-free.

On top of that, when a withdrawal is made and the RESP is in a net loss position, the rules consider that the contributions are what suffered the loss and any EAP comes purely out of the CESG, so that liability goes away faster. But the book value of contributions doesn't disappear, it just doesn't figure in the calculations of the CESG and EAP. Below is a simple spreadsheet to illustrate the calculation.

In the example, the $15,000 loss is such a large deficit to make up with only $35,000 remaining in the RESP account following the withdrawal (which conveniently consumed all the CESG, unlike the profit example), that a new contribution of $10,000 is made to make it more feasible to recover the loss. Of course, new contributions must remain within the $50,000 lifetime maximum permitted for each beneficiary.

A tricky point that caused me needless extra phone calls is the fact that HRSDC only tracks CESG and the contributions related thereto. This means their records only go back to 1998 when CESG started. RESPs existed long before that. The RESP provider is obliged to record all contributions and pass this along with other essential data (like when your plan was opened) to another provider if there is a transfer. HRSDC will provide the subscriber with a written table of all their CESG plus contribution per beneficiary records upon request - phone 1-888-276-3624. If you make contributions after the kids get beyond 17, the maximum age to receive CESG, then HRSDC isn't interested and only your plan provider will keep that data (nor does Canada Revenue Agency keep any data on contributions or CESG).

BMO Investorline to Introduce RESP Accounts

BMO Investorline is to fix the anomaly of not offering Registered Education Savings Plan (RESP) accounts for its discount brokerage customers according to a recent note to clients from Connie Stefankiewicz, President & CEO. Good on them, it's about time. I am hoping it will facilitate online contributions with direct transfers of cash (dare we hope even contributions in kind?) from bank accounts or a regular trading account. The RESPs are to begin in "early fall".

Saving for Children in the UK Compared to Canada

It has been an eye-opener the last few days doing research for some of my Scottish relatives into the Child Trust Fund program (CTF) that exists here in the UK and comparing it to the closest Canadian equivalent, the Registered Education Savings Plan (RESP). The UK government created the CTF only in 2005 - one wonders whether the policy makers took a look at the RESP and decided to simplify and improve it.

The key common point is that both the CTF and the RESP are tax-protected savings accounts for the future of children. Both also enable savings into various types of equity holdings (stocks, funds, ETFs) and fixed income (bonds, bond funds, guaranteed savings). And both receive some direct contribution of funds from the government.

But the differences between the programs abound:

• RESP is intended to be used only for higher education (and tax-exempted accordingly) while the CTF can be used for anything; score one point for the CTF
  
• CTF receives from the UK government only £250 at birth of the child and another £250 at age seven, while the CESG from the Canadian government to the RESP can be up to $400 per year, soon to be $500 according to the March 19 budget (though the lifetime limit remains at $7200); score one for the RESP
• CTF annual contribution limit is £1200 (about $2700 at today's exchange rate) while the RESP's is $4000, a cap that the budget also eliminates; score one for the RESP
• CTF ends at age 18 but RESP can exist gaining tax-exempt income till age 25; score one for the RESP
• CTF assigns ownership to the child from the beginning and the money is locked into the account (except for terminal illness, in which case funds can be used early) till 18, but the RESP doesn't prevent early withdrawal, a flexibility advantage, though the effect of CESG needs to be considered (see HRDC website); debatable which is better, score it even.
  
• CTF on maturity passes directly to the child to do whatever he/she wants while the RESP is still controlled by the Plan holder (most likely a parent); here's a good debating point! should an 18 year-old be put in full control of a potentially large sum to do whatever with, no accountability to anyone required? my view, with my limited experience of my own kids is, they learn to do it, just like they learn to pick up after themselves when they move into their own place; score one for the CTF
• CTF withdrawal is simple and straightforward while RESP is complex and time-consuming with bad consequences if done the wrong way (all that keeping track of CESG vs capital contributions vs income and the proper withdrawal sequence ... ouch it's a bureaucratic nightmare); score one for the CTF
  
• CTF has three sorts of mandated account types (see the first CTF link above for details) that allow easy choice amongst them according to risk preferences and easy comparison within an account type while the RESP multiplicity of investment vehicles is complex and time-consuming to figure out (to see what I mean check out this discussion on MillionDollarJourney's blog); the UK government has succeeded in establishing a level playing field for the CTF that seems to meet general approval, including mine, which counts the most of course ;-) score one for the CTF
• CTF's account-fee cap of 1.5% on the Stakeholder account type, which minimizes profit prospects for providers, has oriented them to offer index-tracking equity funds rather than actively managed funds, which are more likely to under-perform the index; score one for CTF
• CTF and and Human Resources Development Canada (HRDC) both provide listings of approved providers of the respective plans but CTF shows the types of plans of each provider and gives some guidance on how to choose; score one for CTF
• CTF lowest cost self-directed provider of an index tracker fund that I found at the Share Centre comes at about 1.03% total annual fees while for an RESP there is TD CanadaTrust's eSeries which vary from 0.33% for the Canadian Index to 0.48% for the US currency hedged (S&P500) Index or the International MSCI EAFE Index; too bad a CTF holding has to be traded on a UK exchange!; on top of that, there's only fund as cheap here in the UK so one cannot diversify beyond the UK FTSE index; score two for the RESP
  
• UK telephone helplines of both regulators and providers of CTFs are answered quickly
  (within seconds generally) by knowledgeable personnel without going through menu trees and such, while in Canada one can easily wait for minutes (it was about 10 minutes for TD CanadaTrust) or reach only an answering machine; score one for the UK
  

Overall, the RESP seems better for people like me (because my kids have gone on to university) than the UK's CTF, but what a hassle compared to the UK!

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.