RESP Accounts – What They Are And Why They Are Awesome

With education costing a little more every year it has become imperative to try to prepare for the post-secondary journey well in advance.  The bad news is that it is a fact that kids today are paying more for their post-secondary education (even taking inflation into consideration) than ever before.  At the same time, the new world economy is demanding more and more specialized training that high school doesn’t begin to cover.  The reality is that today’s generation, and future ones, are going to want access to some sort of education or specialty training after they turn 18.

Related – Tuition Costs Are On The Rise

The good news however, is that the government has given you a great savings vehicle with which to help your child out.  It is similar to the RRSP accounts that we use to plan for retirement and is called a Registered Education Savings Plan or RESP.  Now I know that some people believe that making each child pay for their own education is a way of teaching them good financial habits and how to work hard.  I’m sure we’ll debate this another time, but for now let’s take a more in-depth look about how to efficiently use RESPs.

resp accounts
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An RESP account can be set up for any child in your family.  In fact the government has allowed for a neat little trick called a family plan whereby if one child does not use the funds allocated to them they can simply be transferred to another child.  The only steps are to apply for and receive a Social Insurance Number for your child (which you would have to do at some point anyway) and then go to your local bank and/or credit union.  Every major institution offers some sort of RESP options.  My suggestion would be to shop around after getting some advice from a fee-only financial advisor.

Perhaps the best part about RESP accounts is that the government will simply match 20% of your contribution right up front to a maximum of $500 (as of 2007).  This 20% is called the Canada Education Savings Grant (CESG).  For example if you deposit $2000 for the year into your child’s RESP, the government would kick in $400.  This means that for the most efficient use of the account you would invest $2500 per year and the government would kick in the maximum of $500 for a total invest of $3000 per year.  Any investment advisor will tell you that a 20% gain over 2 years would be great, and with RESPs you are already at a 20% return on investment the day you invest the money… guaranteed!

The other large benefit is that it grows tax free in the same way an RRSP account or a TFSA account does.  When the money is taken out it is taxed as income for the beneficiary, which is usually a student with very little income for the year; therefore, it usually has an effective tax rate of 0 because with all the deductions students get they would have to make a lot of income before they would not receive all their income tax back in their tax refund.  When the child takes out money from the RESP it is called an Education Assistance Payment (EAP).

Related: TFSA vs RRSP

This all sounds very good, but we all know how sick we are of hearing the banks yell at us about RRSP season being right around the corner and making sure to, “Max out your TFSA.”  We often ask ourselves who has enough money to invest after the bills are all paid and we go out for dinner once or twice a month?”  This investment account is extremely useful, and I’ll show you how if you only invest for a few years, you can really help your child achieve that dream job of theirs without the nightmare of debt that can accumulate.  Here are some basic numbers that can work for you if you start an RESP early enough.  I assumed a 7% interest rate for the first few years and  5% for the last 5-10 years or so.  I’ll explain why after, but I assure you that those are fairly conservative estimates.

Say our fictional child is born in February 2011.  We have until September 2029 before we have to start handing over cheques to those who live in the ‘ivory towers’ of academia.

2011-2015 (5 years) Invest $2500 + $500 from the government.
In 2015 this account will have $17,252 in it.
Say we just leave the account until 2020 at this point, in 2020 it will have 24,196 in it.
In 2020 we’ll start to switch the account into more conservative investments (such as bond ladders) and so by 2029 our original 5 year investment has grown into: $37,535
This means that your original 5 year investment of 12,500 has turned into 37,535.  The main reason for this is because your money has been allowed to compound tax free within the account.  You have been gaining interest on your money, the government’s money, and the interest on your original money!

If you crunch the numbers for merely putting $1,000 per year into your RESP account for 18 years you would end up with about $38,000 as well.  You would have invested $18,000 of your own money, but $1000 per year is a little easier to chew on for most people.

For one last numbers crunch let’s say that $2,500 is invested for 10 years under the same premises as before.  For that 10 years of investment (25K of your money), and then adding nothing, at 18 your child will have an RESP account of about $61,000.

If you would like to enter in some of your own specific numbers there are numerous RESP calculators on the net, just make sure they take into consideration your contribution, the free government 20% match, and compound interest rates.

If you’re wondering where in the world I got my return rates from I’ll try to summarize.  The basic rule of investing is that the more risk you take in your investments the higher your return will eventually be; however, if you need the money within 5 years or so you put yourself at the mercy of that risk.  If you start investing for your child’s education 12-17 years down road you can afford to take on some risk.  With this time frame of investing 7% is a very conservative number as the stock market has on averaged over 10% per year since its inception.  For our virtual investment purposes I gradually shifted over the money in the account from stocks to bonds as the date our 2011 child would need them.  This guarantees the money will be there when they go to take it out.  Most financial experts that I read have been investing in their RESPs with something called an Index Fund.  Index funds basically track the market as a whole and are much less risky than trying to pick specific stocks.  If you want a perfect execution of the strategy I just described take a look at this site http://www.milliondollarjourney.com/resp-portfolio-update-march-2010.htm and it shows how a professional would setup their RESP.

The core philosophy behind RESPs is that the government wants you to save for your child’s education and so they will help do just that.  Both Alberta and Quebec also have similar provincial programs to allow for even more intense saving.  The government will contribute even more to your RESP if you have a family income of under $74,000.  I won’t get into the specifics, but it’s worth discussing with your bank if you fit into this category.  The maximum lifetime contribution for an RESP sits at $50,000, and the lifetime amount the government will chip in under CESG payments is $7,200.  I would bet these amounts will rise with inflation, but if you’re hitting these maximums I’m sure you’ll be more than fine.

The final useful quirk to the program is that you can ‘catch up’ on RESP payments if you miss them for some reason for a year or two.  If you start an RESP and then did not contribute for a year (or contributed less than your maximum) the government will allow you to ‘carry that amount forward,’ but will only give you a maximum of $1000 in CESG money per year.  You can gradually catch up overtime and make sure you maximize your free government CESG money with a little financial planning.  Ask your financial advisor for a specific timeline on this and it should be pretty straight forward.

If you want to make sure you are prepared to help your child financially, as well as emotionally and intellectually as they transition from high school to the working world RESPs are a great tool.  If by some chance your child decides that university, college, trade school, etc. is not for them, then you can transfer the funds to another of your children within the family plan.  If all of your children make similar decisions you can move up to $50,000 from your RESP to your RRSP (provided you have the contribution room) tax free.  Finally, if you have no more contribution room in your RRSP (first of all congratulations, you are in great financial shape) you can choose to take your money out and collapse the account, but you lose the government grant money as well as the interest gained and it is taxed as income.  RESPs are a much better way to support your child’s education than buying them a car and giving them 100 bucks whenever they come home (the traditional method of support).  Do yourself and your family a favour and inquire about RESPs at your local financial institution today.  My parents helped me out through RESP’s to the tune of 4K-5K per year and I am extremely grateful for this, I’m sure your child will be as well!

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