The following excerpt is Chapter 1 of Mike Holman's new book, The RESP Book: The Complete Guide to Registered Education Savings Plans for Canadians.
Chapter 1 Summary
- RESPs are intended to help with a child's post-secondary educational costs. Penalties will be applied if the money is used for other purposes.
- RESP accounts are tax-sheltered accounts that are eligible for government grant money based on contributions. The grants are worth 20% of any eligible contributions.
- RESP accounts can be opened with most financial institutions and can contain a wide variety of investments, from GICs to individual stocks.
- Educational costs can vary between programs. If a student lives at home, his costs will be much cheaper than if he were living on his own.
- RESPs can be used for adults, but the TFSA is a better choice for this purpose.
What is an RESP?
RESP stands for Registered Educational Savings Plan. An RESP is an investment account that can receive extra grants from the government based on the amount contributed. The investments in these accounts enjoy tax-free growth and earnings, meaning more money will be available for future educational costs.
There are many rules, regulations and limits for RESPs, so this book covers the important information that the typical RESP investor needs to know. The basics of investing and how to open an RESP account are also outlined.
RESPs can be opened at most banks, with a financial advisor or even on your own as a self-directed RESP. Scholarship, group or pooled plans are also available, but I don't recommend them because of high costs and restrictive rules.
It's important to know that RESPs are a type of investment account, not a type of investment. You can put the same types of investments in an RESP as a Registered Retirement Savings Plan (RRSP). Guaranteed Investment Certificates (GICs), stocks, bonds, mutual funds, exchanged traded funds (ETFs) and good old cash are all eligible investments for your RESP.
The purpose of having an RESP account is to help save for a child's education. Typically, parents open RESPs for their own children, but you can open an RESP account for any child.
6 Reasons to Start an RESP
There are many reasons why you should start an RESP. Saving for your child's education will likely improve the odds that she will participate in post-secondary education by diminishing financial barriers and building a financial nest egg. An RESP account should make it easier on your budget when she is in school.
Here are some of the great things about RESP accounts:
i. CESG (Canadian Education Savings Grant)
RESPs can receive extra grants called CESGs from the government based on the amount contributed to the account. CESGs are worth 20% of each dollar you contribute and are basically free money. The CESG is the single biggest reason why an RESP account is usually far superior to any other type of savings or investment account for educational saving purposes.
ii. Tax-free compounding
All interest payments, dividends and capital gains earned inside an RESP account are not taxable. This means you get to keep all of the money earned, increasing the amount of money available for your child's education. If you start the RESP account when your child is young, there will be many years for that investment to grow tax-free.
iii. Dedicated savings account
It is a good idea to have a separate savings account for a major financial goal like post-secondary education. If this money were mixed in with other types of savings, it would be easier to spend it on items other than education.
iv. Reduce your liabilities when your child is at school
Some parents find themselves in the situation where their child is attending college or university, and they end up having to funnel a large amount of their budget to pay for the schooling. With a fully funded RESP, there should be little or no financial demands on the parents once the child starts post-secondary education.
v. Reduce student loans for your child
One alternative to parents paying for a large amount of the education is for the child to apply for student loans. While this strategy isn't the worst thing in the world, it would be ideal for the student to avoid any debt while in school.
vi. Reduce your child's need to work during the school year
I'm a big fan of students working during the summer, but I don't think they should have to work during the school year. Students should be free to work hard in their studies while also participating in sports or social activities.
6 Reasons Not to Start an RESP
RESPs are not for everyone. If you are not in a position to make contributions to an RESP, you should wait before opening one.
Here are some reasons to avoid opening an RESP account:
i. You need to get your finances in order
If you have excessive debts or spend more than you make, you should wait to open an RESP. You might end up cashing in the RESP to pay your bills, defeating the purpose of setting up the RESP in the first place. It is important to get control of your finances and fix the here-and-now before worrying about the future.
ii. Your retirement savings are inadequate
There is no exact amount of retirement savings you should have at any given age, but if you are working full time and don't have any retirement savings, you are not saving enough. The older you are and the less you've saved, the more you should worry about saving for your retirement rather than saving for your child's education. Your child can borrow to pay for her education, but you can't borrow for your retirement.
iii. No extra money in your budget
If your finances are in good order but you don't have any extra money, you obviously can't make RESP contributions. In this case, you might want to consider trimming your budget in order to free up some money for RESP contributions. Another idea is to look at ways to make extra income so that you can save for your child's education.
A great book for money-saving ideas is 397 Ways to Save Money by Kerry Taylor.
iv. Pay-as-they-go educational funding strategy
One common strategy for parents is to pay down all their debts before the child starts school. Once the child starts post-secondary education, there should be lots of extra cash in the budget to pay for education bills. The drawback of this plan is that you don't get any of the juicy RESP grant money.
v. You want your child to pay for part or all of the education
It is reasonable to ask your child to pay for part of her education. The drawback of this plan is that she might end up not going to school or dropping out if the financial burden is too onerous. If the student works part-time during the school year, her grades could be affected. Alternatively, she might graduate with large student debts.
vi. Your children are too old or ineligible for RESP grants
The last year your child can receive a grant in her RESP is the year she turns 17. However, children who are 16 and 17 are only eligible for grants if they meet certain eligibility requirements, which are outlined in Chapter 3: RESP Contributions and Grants. Creating an RESP for a child who is ineligible for the RESP grants has very limited benefits and is likely not worthwhile.
How much should you contribute to an RESP?
The amount you contribute to an RESP is highly dependent on your personal financial circumstances. Here are some things to consider when deciding on your contribution plan.
What are your goals?
Do you want to pay for all of your child's educational costs? Half of them? The more money you want to have available for post-secondary education, the higher the contributions will have to be and the sooner you'll need to start the RESP account.
How many years until they go to school?
If you wait until your children are older to start an RESP account, there will be less time for contributions and investment growth. This means that larger contributions will be required, compared to someone who starts the RESP when the children are young.
How much can you afford?
In order to get the maximum annual RESP grant of $500, you must contribute $2,500 per year or $208.33 per month to the RESP account. The reality is that many people might not be able to spare this much from their budget. My philosophy is that something is infinitely better than nothing, so even if you can only handle $50 per month, you should do it. If your finances improve in the future, you can always increase the monthly contribution. Even if you only contribute $50 per month from when the child is young, that will still add up to a substantial amount by the time the child goes to school.
Will the student be living at home while attending post-secondary school?
In my mind, this is one of the two biggest uncertainties regarding post-secondary education costs (the other being whether the child will attend post-secondary school at all). The problem is that the amount of money required for a student to attend school out of town is roughly twice the amount necessary if they live at home. By the time you find out where the child will be going to school, it will be too late to adjust your RESP contribution strategy.
One solution is to save just enough for the student to live at home and go to school. If he wants to go to school in a different city, he can pay the extra costs himself. This plan only works if there are schooling options in your city.
My plan is to make the maximum contributions for my children and just keep the excess amounts for myself if they end up going to school in our city. If they are living at home, my children probably won't need the entire RESP savings.
Other options for utilizing excess contributions include:
• Give them to the child after graduation to help get her started.
• Use them for further education, such as a Master's degree.
• Contribute them to another RESP for a younger sibling.
Will you be working or retired when your children go to school?
For younger parents, there is a pretty good chance that they will be working during the child's school years. If their RESP account savings are insufficient, younger parents can probably make up the difference from their income -- which reduces the pressure of making large RESP contributions.
For older parents like myself, there is a reasonable chance that they won't be working during the child's post-secondary school years. If you will be retired when your child is attending post-secondary education, your options will be limited if the RESP account does not contain enough money. In this case, it is more important to make sufficient RESP contributions during your working years.
Future post-secondary educational costs
Every once in a while, a financial institution does a study on future educational costs and releases it to the media. This is done to encourage parents to contribute more money to their RESP accounts and to help those financial companies make more money.
I usually find these studies quite depressing because they always foresee incredibly large future educational costs. You will often see estimates well in excess of $130,000 for a complete post-secondary education.
For several reasons, I decided to ignore these reports and just come up with my own estimate. My estimate might not be perfectly accurate, but I doubt it is any less accurate than the scare reports issued by financial companies.
7 Problems with educational cost estimates in media reports
i. Conflict of interest
Any company that offers RESP accounts has a vested interest in publishing studies that promote RESP sales. By making more aggressive assumptions about future costs, a company can easily inflate future educational cost estimates.
The direct costs of education, such as tuition, have been rising at rates significantly higher than inflation. Most studies assume that this trend will continue indefinitely, which may or may not actually happen.
iii. Living costs
Items like food, shelter and other living costs are difficult to estimate and are quite controllable by the student. I suspect these studies estimate these costs on the high end.
iv. RESP will pay 100% of educational costs
These studies assume that the RESP account is the sole source of funds to pay for your child's education. The reality is that your child may have other sources of income to pay for school.
Most students work in the summer or on co-op work terms and can help pay for some of their educational costs. Some students will work during the school year as well. Lastly, unless parents are in a dire financial situation, they should be able to throw in a bit of cash for any shortfalls as they arise. And of course student loans, grants and scholarships might be a possibility as well.
v. Will the child be living at home?
Most future educational cost studies I've seen assume the child will not be living at home - which of course adds greatly to the cost. This assumption ignores the huge cost reduction that is possible if the child lives at home during post-secondary schooling.
vi. Future dollars
Most of these studies use future dollars, which result in larger estimates because of the effects of inflation. Most of your RESP contributions and earnings will be in future dollars as well.
vii. They project 17 years into the future
In order to maximize the shock effect of the estimates, the timeline of the studies is usually 17 years, which adds to the future cost because of inflation. This estimate would be relevant for a brand new parent whose child won't be going to school for 17 years, but for parents with children who are not newborns, the estimate is too high.
Let's work through a scenario
One estimate for current post-secondary educational costs is $77,132 for a student going to school out of town and $51,763 if the student lives at home.
That may sound like a lot of money, but let's work through the numbers to find out how this amount can be paid without relying 100% on the RESP account. The dollar amounts are all in today's dollars for easier comparison. I'm assuming the RESP contributions start in the child's first year.
Scenario 1: Student does not live with parents
The total amount needed for educational costs in 2010 dollars is $77,132.
Let's assume the student works during the summers, saving $1,000 for her first year and $2,000 for the second, third and fourth years. The total saved from her summer jobs is $7,000. With the extra savings, the student's total education costs are now $70,132.
Her parents will pay $2,400 per year ($200 per month) from their regular budget for all four years of schooling. Their total contribution of $9,600 brings the student's total costs down to $60,532.
Assuming withdrawals from the RESP account will fund the remaining shortfall, let's tally how much should be contributed each month:
If you assume a real rate of return of 4%, you will need to contribute $163.83 per month in order to reach this goal. This results in an annual contribution of $1,966, which is well short of the maximum $2,500. The RESP grant would be paid on top of that contribution amount.
Scenario 2: Student lives with parents
Total amount of money needed in 2009 dollars is $51,763.
In this scenario as well, we will assume that the student can save $7,000 over the four years and that the parents will chip in $9,600, leaving us with a shortfall of $35,163.
Assuming a real rate of return of 4%, the monthly RESP contribution amount necessary to make up this shortfall is only $95.17 per month! This works out to an annual contribution of $1,142 -- which is less than half of the maximum contribution amount.
These scenarios show that you don't have to contribute the maximum amount every year in order to ensure that your child has enough money for post-secondary education.
As for the problem of not knowing if your child will be living at home, you can contribute enough to pay for the child living away from home, and then keep the contributions for yourself if she ends up living at home.
RESPs for adults are a waste of time
RESPs are not just for kids. You are allowed to open an individual RESP for yourself and make contributions that can be withdrawn for educational purposes.
The RESP rules for adults are similar to the rules for children except for that there are no government grants available, greatly reducing the attractiveness of this strategy.
The main drawback of the RESP account is the penalty on earnings (20% tax in addition to income tax) if the beneficiary doesn't go to school. For a younger person, the free government grant makes the risk worthwhile. In my opinion, this risk is not worthwhile for an adult who can't qualify for the RESP grant.
Adults who want to save for their own education should consider using the new Tax Free Savings Account (TFSA). This account is tax-sheltered and doesn't have any withdrawal penalties.
Excerpted from The RESP Book: The Complete Guide to Registered Education Savings Plans for Canadians. Copyright (c) by Mike Holman.
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