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Education planning and registered education savings plans (RESPs) is often at the forefront of discussions that financial advisers are having with many investors – whether these clients have children in a postsecondary institution or saving for them to go into one in the future.

The RESP is an enticing vehicle for investors because the federal government provides a 20-per-cent matching grant through the Canada Education Savings Grant (CESG), which is subject to both an annual maximum of $500 and a lifetime maximum of $7,200. The unused CESG accumulates each year a child is alive, even if no RESP is open. And if no contribution was made in a year of the child’s life, a double contribution can be made to reach back for a year of the grant. There are no annual limits on contributions, but there is a lifetime limit of $50,000.

When investors contribute toward a child’s RESP, conventional wisdom tells us that they should take advantage of the free money in the 20-per-cent CESG. But is that always the right decision? Let’s consider three scenarios for contributing to the RESP, assuming a 5-per-cent annual rate of return:

Scenario 1

The investor contributes $2,500 a year, beginning when the child is first born, to the maximum of $50,000. The RESP receives $7,200 from the CESG and produces total income and growth of $43,654. The total value of the RESP when the child is 19 years old is $100,854.

Scenario 2

The investor contributes $50,000 into the child’s RESP in the first year of the child’s life. The RESP receives only $500 in CESG, but produces income and growth of $83,492 for a total RESP value of $133,992 when the child is 19 years of age.

Scenario 3

The investor contributes $16,500 into the child’s RESP in the first year, then contributes $2,500 a year thereafter until reaching the lifetime limit of $50,000. The RESP receives the full CESG of $7,200 and produces income and growth of $62,386. The total value of the RESP when the child is 19 is $121,486.

What this shows is that front-loading RESP contributions is more valuable than receiving the government grant. Of course, for many people, putting $50,000 into an RESP in the first year of a child’s life is unfeasible, but the more that could be invested at once earlier on, the better.

If the RESP is maximized and additional educational savings are desired, two other methods can be used to save for a child’s education. First, if the child is 18 years of age or older, she will have contribution room in her tax-free savings account (TFSA). Thus, contributions could be made to the child’s TFSA to supplement the RESP. Second, if the child is under the age of 18, an informal trust could be used to save for her education. (A note on taxes: If the contributions to the informal trust come from the parents, then income from the account will attribute to the parents for tax purposes, but capital gains will not.)

When it’s time for the child to draw down on the RESP, the account is divided into three sections: contributions, CESG, and income and growth. The contributions could be withdrawn tax-free; but the the CESG and the income and growth must be withdrawn as an Educational Assistance Payment (EAP), which is taxable to the child.

There are no restrictions on withdrawing the contributions once the child is attending a postsecondary institution. The EAP does have some additional rules. The main ones are that the child must provide proof of attending a qualifying institution and that the withdrawal is limited to $5,000 in the first 13 weeks when the child begins postsecondary education.

Those restrictions aside, it’s best to maximize the EAP withdrawals over the contributions wherever possible. Any remaining grant is repaid to the government and any remaining income or growth is taxable to the subscriber (parent) as an Accumulated Income Payment (AIP).

The AIP not only has the detraction of being taxed at the subscriber’s marginal tax rate, but also carries a 20-per-cent tax penalty on top of that. The 20-per-cent tax penalty is taken off the top and then the remaining 80 per cent is included as income to the subscriber. The only ways to avoid this tax penalty and retain the value of the assets in the RESP are for the investor to transfer up to $50,000 of these assets to his or her registered retirement savings plan, if he or she has the contribution room, or to another child under a family RESP plan.

Having these EAP payments taxed in the child’s hands is the most advantageous. Even if the child is working while she’s in school and has income in excess of the basic personal amount, her education credits will be enough to offset any taxes owing from the RESP, in most cases.

As much as it’s advantageous to maximize the EAP, in the case of a family RESP, the subscriber must ensure he or she doesn’t exceed $7,200 of CESG withdrawal per child. Each child is permitted only $7,200 of CESG as a maximum. Thus, if more than that amount is withdrawn from the CESG for the older child, the government will demand repayment and take the overpaid grant funds back from the RESP. That, in effect, means those assets are lost to the younger child.

The RESP is a great savings tool. Understanding its intricacies will help to maximize its value. On the flip side, failure to do so could be a costly mistake for investors and their children.

Matthew Ardrey is vice-president and wealth advisor at TriDelta Financial Partners Inc. in Toronto.