RESPs: Why, when and how

An RESP is an investment account designed specifically to help you save for a child’s post-secondary education. Not only does the money grow tax-free, but the government chips in with substantial grants. That’s why Martin Leahy and his wife Renee opened one after their daughter Caitlin was born two years ago. While Leahy makes a comfortable living as an emergency room physician in Ottawa, his career is time-consuming and stressful. He’s 40 and anticipates being retired by the time Caitlin is in university. “As a doctor, I don’t get a pension,” says Leahy. He wants Caitlin’s college fund to be secure when he and his wife are living on a fixed income.

Leahy found setting up an account was easy—all you need is a Social Insurance Number for each child—but choosing your RESP provider can be daunting, since there are many investment options, as well as fees and penalties you need to be aware of.

MoneySense will take you through everything you need to know about RESPs, from setting up an account, to choosing the investments, to unwinding them when your children start their post-secondary education—or collapsing them should they decide not to pursue studies after high school.

What are the benefits?

If someone asked if you’d like a 20% return on every dollar you squirrelled away for your child’s post-secondary education (be it university, college, apprenticeship or trade school), chances are you would emphatically say yes. Well, that’s exactly what the government does for you with an RESP. “There’s really nothing else like it available. This is free money,” says Mike Holman, author of The RESP Book: The Simple Guide to Registered Education Savings Plans for Canadians.

With an RESP, the first $36,000 you contribute is eligible for the 20% Canada Education Savings Grant (CESG), which works out to up to $7,200 per child. There are, however, many rules and restrictions. If your child was born in 2007 or later, the maximum contribution eligible for the grant is $2,500 per year, up to and including the year the child turns 17. That works out to a grant of $500 annually. If you don’t max out your annual CESG the eligibility room carries forward, but $1,000 is the maximum grant you can receive in any one year.

There is no limit to how much you can contribute yearly, although there is a lifetime maximum of $50,000 per child.

When should I start?

The answer is simple: now. Don’t worry if you can’t contribute anywhere close to $2,500 a year: most new parents can’t. Putting in $50 per month, or whatever you can afford, is a good start and you can always increase contributions later. Moreover, provincial and federal governments have several added incentives to help low-income families (see www.canlearn.ca for complete details).

Remember, you have a limited amount of time to take advantage of the CESG. Because you can’t collect more than $1,000 in any given year and the grant stops after the child turns 17, you need to open the RESP when your child is no older than 10 if you hope to collect the full $7,200 in grants. And if you wait until your child is 16, you’ll miss out on any chance of receiving the government money.

Still, RESP contributions should always be weighed against one’s current financial priorities as well as their long-term planning, cautions Jason Heath, a fee-only financial planner with Objective Financial Partners in Toronto. “That instant 20% grant is great, and maybe one can expect a 5% to 8% long-term return,” Heath says. “But if someone is paying a high rate of interest on consumer debt, that cost will outweigh the RESP benefits. There needs to be a balancing of Mom and Dad’s finances and retirement planning relative to the needs of the kids and education planning.”

What are my options?

When Faith Bisram and her wife Ali adopted their nine-year-old daughter Moechia this year, amid all the exciting changes in their home in Brampton, Ont., questions about RESPs loomed. “We knew we needed to seriously think about it,” says Bisram, but they were unclear about their options.

Until the government introduced the CESG in 1998, group plans—also known as pooled or scholarship RESPs—were popular options for post-secondary education savings. But today almost every financial institution offers self-directed RESPs that are more transparent and flexible.

Group RESPs have developed a murky reputation due to the aggressive, sometimes crass tactics used by some of their sales reps. Take Dave Carpenter and his wife Kira Vermond’s experience at a farmer’s market in Guelph, Ont. “There was a woman handing out balloons to all these kids and it turned out she was selling RESPs,” says Carpenter. “It seemed like such an insidious way to bring parents with kids over to the table.”

One problem with group RESPs is that they have high fees that are often not disclosed on statements. Worse, says Holman, if you decide to close the plan before it matures, you face heavy penalties.

Pooled RESPs do have a couple of things going for them. The investment decisions, conservatively put into fixed income, are all made for you. Busy parents or those skeptical about the stock market may appreciate this. Also, if the child stays in the plan until maturity there is a top-up benefit, which is funded by those who leave early. But on balance, the high costs and restrictive rules outweigh any benefits, says Neil Jain, a fee-only financial consultant in Toronto.

This is why Jain and Holman recommend self-directed RESPs, which provides more investment options, flexible contribution schedules and more control when it’s time to take the money out. But don’t let the term “self-directed” intimidate you. While you can manage your RESP portfolio on your own by opening an account with a bank, credit union or discount brokerage, you can also work with a financial adviser.

The next option is deciding whether to go with an individual or family plan. Individual plans can be opened for any one child, while family plans are intended for multiple beneficiaries. Holman says family plans may be preferable if you have more than one child because they simplify the process and may reduce costs.

How much do I need to save?

Before you start contributing to your RESP, first think about what you want to achieve. “Do you plan to pay all your child’s tuition?” asks Jain. “Do you plan to pay all their room and board if they’re living in a different city? Do you expect your child to earn some money through a summer job and contribute also?”

Dave Carpenter, who has a six-year-old daughter and 10-year-old son, says he and his wife plan to pay for at least half their children’s costs. His homework suggests the full cost of schooling away from home may be about $80,000 over four years, which is in-line with current estimates offered by Canadian university websites.

That number was also close to the mark for Toronto financial planner Barbara Garbens, who tracked the expenses of her own daughter, a recent university graduate. Taking into account tuition, rent, books, food, transportation to and from home as well as incidentals, Garbens found her daughter’s yearly costs averaged about $20,000—not including the cost of a cellphone, clothing or partying. Those extras could easily push yearly costs to $25,000 “for the parent who wants their post-secondary-age kids to have it all,” adds Jason Heath.

For parents looking to cover just the basics, he says, annual costs range between $15,000 and $20,000, depending on the city. But, he stresses, those are current costs. “If someone had a newborn today, they’d need over $120,000 to fully fund a four-year undergraduate program and associated costs based on $17,500 a year and 3% inflation.”

If even today’s four-year estimate of $80,000 seems like a gigantic expense, Holman points out many students will be able to contribute a few thousand dollars a year from summer jobs or co-op terms. Remember, too, that not all the costs of university life will be completely new: you’re already paying for your children’s food, sports activities and daily living expenses, so you may not need to pay for them from your RESP budget once they leave home. Holman suggests about $2,400 annually (or $9,600 over four years) of your student’s expenses can come from the family’s regular budget. These adjustments might bring your RESP savings goal down to $60,000 or so. If you start saving as soon as your child is born, you can achieve that goal in 18 years with an annual contribution of $2,000 (about $167 a month) and a 4% annual return. That would also allow you to collect the maximum CESG.

How should I invest?

Now that you’re committed to saving with a self-directed RESP, it’s time to determine how to invest your contributions. Investing for a child’s education is different from saving for retirement. First, the time horizon is relatively short: you’ll likely contribute to an RESP for a maximum of 18 years, compared with an RRSP, where your horizon may be 40 years or more. That means you have less time to ride out dips in the market. Second, you will probably need to withdraw all your RESP money during a short window of three to six years. The upshot is it makes sense to be conservative with your education savings, especially as the child gets older.

Jain offers a simple formula for gradually shifting an RESP from a portfolio more heavily weighed in stocks to one mostly in bonds and cash. “The key is that every two years, shift the balance 5%,” he says. Parents could start with 75% equities and 25% bonds when their child is born, then shift it to 70%/30% at age two, and so forth. “By the time the child is 14, you’re at 40% equity and 60% bonds,” he explains. Once the child is 16, the RESP should be locked into at least 80% fixed income. Keep in mind that diversified bond funds can still lose money over periods of three or four years, so as a child gets older, the money should be in short-term bonds, GIC rate, or a high interest savings account.

If market volatility is no concern, you could go with a very aggressive portfolio out of the gate, investing 100% in a well-diversified equity portfolio. But parents with no stomach for risk—or little experience with investing—should probably keep their RESP money in GICs or high-interest savings accounts. As they learn more about investing, they can always switch to a different portfolio. Savvy investors can build their own Couch Potato portfolio by using index mutual funds: this requires more work but will save you money because annual management fees will be much lower.

Martin Leahy, who has a self-directed mutual fund RESP, chose a classic balanced approach, split equally between equities and bonds. As the years pass, Leahy’s adviser will make the portfolio less aggressive.

Dave Carpenter uses the RBC Target 2020 Education Fund, which has an asset mix that evolves over time: there’s a greater weighting in equities early on and a more conservative mix favouring fixed income as the child gets older. “That was part of the reason for picking this particular fund: I don’t have to worry about switching from higher risk to lower risk,” says Carpenter. “It’s just going to happen.”

The Bisrams are in an unusual position: because they adopted Moechia when she was nine, they’re starting her RESP halfway through the usual investment horizon and aren’t in a position to be aggressive. If they’re fine with a little risk, Holman suggests they can start off at about 50% equities and move a little more into bonds every year or two. However, if that makes them uncomfortable, they could simply opt to keep all the savings in bonds or GICs. “You could argue that a no-equity portfolio wouldn’t be much worse,” Holman says.

Regardless of how they want to invest their RESP, the Bisrams are still in a position to maximize their CESG money. If they invest $5,000 annually for seven years (making up for those years where no contributions were made), they will receive almost all of the grant money to which Moechia is entitled.

How do I withdraw money from an RESP?

Once your child is enrolled in a post-secondary institution, you can begin to withdraw your RESP money. In theory, the process should be simple: you’re required to provide proof the child is enrolled at an approved post-secondary school each time you request a withdrawal. “You don’t need to provide receipts for tuition or books, or anything like that,” Jain explains.

But accessing your funds can be time-consuming and frustrating, warns Alan Whitton, author of the Canadian Personal Finance Blog (canajunfinances.com). With one child who is nearly finished university, another who’s halfway through, and a third who is just starting, he’s a veteran of RESP withdrawals. Whitton says the regulations have become much tighter in the last few years, thanks to abuse of the system by parents whose children didn’t attend post-secondary institutions. In the past he could take out funds electronically or over the phone, but he’s now required to do it in person at his bank. The paperwork is dizzying, he says. “The paper trail is to protect the bank’s interests, not necessarily yours or the student’s,” he says.

Not all RESP providers have the same requirements, so it’s best to contact your financial institution several weeks before you need the money and ask about their specific policies for RESP withdrawals. (It’s worth adding that if you’re invested in bonds or GICs you want them to mature a few weeks before you plan to withdraw the funds.)

There are important tax strategies to bear in mind when tapping your RESP. For starters, there are two types of withdrawals. Post-Secondary Education payments (or capital withdrawals) are taken from the contributions you’ve made with your after-tax income, so there is no more tax owing upon withdrawal. Educational Assistance Payments, or EAPs, are taken from the growth of the RESP. (Note that your statement may describe this amount as “accumulated income,” but it includes not only interest and dividends, but also any capital gains and all the grant money.) EAPs are taxed in a child’s hands, but students can claim tuition and education tax credits, and if they have a low income, they should pay little or no tax.

When extracting RESP funds, you can specify which type of withdrawal you want to make. “It usually makes sense to withdraw the EAP portion first,” says Jain. That way, if the child ends up completing her education (or dropping out of school) before the RESP account is empty, most of the remaining money can be taken out without taxes or penalties. While only $5,000 in EAPs can be withdrawn during the first 13 weeks of school, there is no maximum withdrawal after that.

What if my kid doesn’t go to school?

If you have a self-directed RESP account and your child forgoes post-secondary education, there are options. With family plans, the funds can be transferred to another child (the $7,200 CESG limit still applies). Another strategy is to wait, says Holman. “You can keep it open for 35 years from the time it started,” he says, pointing out that your child might decide to enroll in university later.

If you want to collapse the RESP, your contributions belong to you tax-free, but the CESG money goes back to the government. The rest of the growth is returned to you as a lump-sum Accumulated Income Payment (AIP), which is not only fully taxable the year you receive it, but also subject to an additional 20% tax.

There are ways to avoid this excessive tax hit, however. If the child is over 21 and the RESP has been open for 10 years, you can transfer the AIP to your or your spouse’s RRSP (to a maximum of $50,000). If you have no RRSP room, Holman suggests waiting a year or two before collapsing the RESP so you can reduce your RRSP contributions and build up more room.

More than ever, parents expect their children to pursue higher education: the number of Canadian post-secondary students increased by 18% between 2004–05 and 2009–10. An RESP remains the best way to help your child join that group. M