This post is part of the Big RESP Series. See the entire series here.
See the previous post on Individual and Family Plans
I did an analysis of some different resp and non-registered account scenarios (child goes to school or not) in order to determine the different amounts of money that would result from each scenario. The idea was to try to see how well the resp does in the different situations compared to putting the money in a non-registered account. Thanks to the Money Gardener for the idea.
The spreadsheet showing all the calculations is here. Basically it’s an account with $150/month contributions into an equity security. In real life an investor might switch to a more conservative portfolio later on but I decided to keep it simple for this example.
Some assumptions
The equity return is 0.5% per month which works out to just over 6% per year, it also gets a 2% dividend at the end of each year. The dollar figures were calculated at the 18 year mark which is when the student would normally be going to school.
The average tax rate on the withdrawal of the subscriber who is working is 40%, subscriber who is retired is 15%
Scenarios:
- RESP account – student uses the money for school. This scenario is the typical “hoped for” scenario where the student uses the money to go to school. I assume that the student doesn’t pay any income tax on this money. All dollar figures are future dollars.
- RESP account – subscriber collapses plan before retirement. If the child doesn’t go to school then the subscriber will pay the marginal tax rate on the income in the account.
- RESP account – subscriber collapses plan during retirement. In this case the student doesn’t go to school but since the subscriber is retired they have a lot more flexibility with respect to income tax rates. Keep in mind that the plan doesn’t have to collapsed until the 26th year of it’s existence so there is time to do this option even if you are working when the child decides not to go to school.
- Non-registered account – money is withdrawn before retirement. For non-reg accounts since the money is always taxed to the owner of the account it doesn’t matter whether the child goes to school or not – the taxation is the same.
- Non-registered account – money is withdrawn during retirement. In this case the capital gains paid by the account owner will probably be less than when they were working.
Results
|
Scenario # |
Scenario |
Amount of $$ |
| 1 | RESP account – student uses the money for school. |
$87,556 |
| 2 | RESP account – subscriber collapses plan before retirement. |
$51,870 |
| 3 | RESP account – subscriber collapses plan during retirement. |
$64,039 |
| 4 | Non-registered account – money is withdrawn before retirement. |
$62,284 |
| 5 | Non-registered account – money is withdrawn during retirement. |
$66,953 |
Analysis
If the child goes to school then the RESP account is the clear winner with a total of $87,556. The non-reg account would only provide $66,953 or $62,284 depending on if the account owner is retired or not. This is not surprising considering the 20% grant available to the resp as well as the zero tax drag during the accumulation phase.
If the child does not go to school then the results are dependent on if the subscriber is working or retired when the plan is collapsed. If the subscriber is retired then there is not much difference between the resp ($64,039) and non-reg account ($66,953). If the subscriber is working, then the non-reg ($62,284) fares quite a bit better than the resp ($51,870).
Conclusion
If your child goes to school then the RESP account will have about 30% more money than the non-reg account. If the child does not go to school then the non-reg account will have 5% more money than the resp if the subscriber is retired, if subscriber is working then non-reg account will have about 19% more.
Bottom line is that if you are an older parent (like me) and are pretty sure that you’ll be retired (or can control your income) by the time the resp plan is 26 years old then the resp is the winner hands down. If you are a younger parent then the choice is not so clear, although there is a big upside (30%) to the resp, there is also a significant downside (19%) if the child doesn’t go to school.
Things to think about
Commander T pointed out that if you transfer the non-contribution portion of a collapsed RESP to your rrsp (if you have the contribution room) then you can avoid the 20% penalty. I personally don’t plan to have this much room, but this is a great strategy if you can do it.
One strategy to think about if you are a younger parent is to wait a few years before starting the resp account since that’s when the clock starts ticking on the age of the account. If the child doesn’t go to school then collapsing the resp plan when you have no other income will reduce the income tax considerably. Most younger parents have mortgages, rrsp room so waiting a few years to start the resp is probably a good idea anyways.
How many kids? Having two or more kids will improve the odds that the resp money will get used since you can transfer between beneficiaries. This generally only works if the older child doesn’t go to school or they are very close in age.
Trusts
Establishing a trust for your child is another method of funding their education and saving taxes. The reason I didn’t get into trusts here is because I consider them a completely different animal compared to non-reg accounts and RESPs. Unlike RESPs and non-reg accounts where the parent owns and invests the money and controls the account all the way through the process, with a trust you give the child the money and will never get it back. My problem with this is that if the kid doesn’t go to school then I don’t want him to get any of the education money since he probably doesn’t need it. This is not to say I wouldn’t help him out if he needed it. The other problem I have with trusts is that it might encourage the child not to go to school. Think about it, if you are 18 and have a trust account with $50k in it and you have a choice between going to school or buying a fancy sports car or travelling the world for a few years – which would you choose?
There is a third option for RESP’s. You are allowed to collapse up to 50,000 of the taxable portion into an RRSP (the non-taxable portion can be taken out without tax consequenses). The advantage to collapsing into an RRSP is no penalty tax is payable. Of course in order to transfer the money into an RRSP contribution room must be availiable.
Avoiding the 20% penalty tax could make a significant difference to these calculations.
Trent
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CT – thanks for the great comment!
Yes, you are correct that the 20% tax can be avoided this way – I really should have mentioned it in the post (I will add it). The issue with trying to evaluate this strategy however is that the money goes into an rrsp which will be taxed upon withdrawal at a future date. All the other figures I’ve given are cold hard cash, after tax, after penalty.
Mike
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Great summary. Very helpful!
One other thing to consider. Pretty much any post-secondary education qualifies, including: apprenticeships, trade schools, CEGEP, colleges and universities. So, it doesn’t matter if your kid goes to university to become a lawyer, takes an apprenticeship to become a plumber, goes to trade school to become a mechanic or goes to commmunity college to become a pharmacy technician, the RESP can be used, though I suppose the different programs would use different percentages of the money.
Great point about the possible benefit of opening the account later rather than earlier. I’ll definitely have to take that into consideration.
Question about your methodology, and forgive me if I missed something you stated. I know you were basing it on an equity security. What rate of return were you estimating, and are the dollar figures given assuming the full 26 years of growth and contributions without withdrawing anything at say, 18 years in?
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Hi Fecundity – good point about the flexibility of what qualifies as post-secondary education.
different programs would use different percentages of the money.
This isn’t really relevant – when you make withdrawals you just ask for the money, no receipts are necessary. It’s important to withdraw every penny even if some of it isn’t needed for education, otherwise you will get nailed with higher marginal tax and the penalty.
As far as opening the account later – I wouldn’t put too much stock into this advice simply because the rules keep changing so the odds of this rule staying the same for 26 years are not that great – that said the 26 year rule might get shortened as well.
Methodology – there is a link to the spreadsheet on in the post – although it’s probably not that easy to figure it out. I will add the assumptions into the post.
The equity return is 0.5% per month which works out to just over 6% per year, it also gets a 2% dividend at the end of each year. The dollar figures were calculated at the 18 year mark which is when the student would normally be going to school.
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Ah, excellent. Thanks.
Huh. Your spreadsheet is clear and well done. I just missed it. Sorry about that. I’m choosing to blame the pregnancy.
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Great series, perhaps you can do the comparison now with the new TFSA – Tax Free Savings Account as an update to this article.
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Thanks Meshwork – that’s a good idea. For a high income earner the TFSA would definitely be superior to the open account but probably not quite as good as the RESP.
I’ll put it on my list!
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Very informative to somone like me who is a novice investor.
Thank you. I will be opening one tomorrow at 2pm!
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Good discussion – I have a question – if you are contributing to an RESP from a Trust, who pays interest on the initial contribution? The contributing trust wouldn’t as it is set up as a payable at year end which eliminates tax in the hands of the trust. If the beneficiary is either a minor, or a trust established for a minor (both cases under a RESP) I would assume that the minor, or the minor’s trust would have the liability for the tax on the initial contribution – correct?
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PTR – I don’t understand your scenario.
What interest are you talking about? Tax on the initial contribution? Huh?
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Sorry, that should have read “tax” not interest. Thanks.
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PTR – still not sure what you are talking about. Sorry.
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OK, I’ll try to clarify. Have a situation where a family trust is contributing to an RESP for a minor (likely to a trust). Is the contribution taxable? If so, who is taxable – the contributing trust, or the minor?
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PTR – there are no tax implications to a contribution to an RESP.
Are you referring to the withdrawal from the trust?
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Yes, the tax on withdrawal from the trust.
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Ahhh – that makes sense now.
From what I understand about informal trusts – any capital gains taxes have to be paid by the owner of the trust ie a parent who has an ‘in trust for’ account for their child.
I’m not sure about a formal trust – maybe the trust itself pays the tax? You should really talk to a professional about this one – or the administrators of the trust.
One thing I know for sure is that the fact the money is going to an RESP has nothing to do with the trust tax issues.
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Under scenario #4, have you assumed that the non-registered account would be in the child’s name? If so, the taxable portion capital gains would not be attributable to the parent during the child’s younger years (i.e. 0 to 18 years). Dividends would be taxed in the parent’s hands as they are attributable. Since the capital gains would be taxed in the child’s hands and they get the personal tax amount free each year, it would be safe to say that a strategy could easily be built to get tax-free capital gains. Would this not save an additional $7,470 on the non-RESP acct?
John
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Hi John – thanks for the comment.
I did not make that assumption – I assumed the non-registered account would be in the parent’s name. The idea is to compare with the resp where the money is always owned by the parent until it is given to the student.
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“when you make withdrawals no receipts are necessary” So say the equity-based RESP has grown very large and the student’s post-high school training is relatively inexpensive, could the student use the funds to put a downpayment on a condo and buy a car, for example? (After all, they will still pay personal income tax on the withdrawals, so the gov’t gets its cut.) E.g.: $150,000 RESP withdrawn over three years of community college with $20,000 for school tuition and the balance for purchase of condo and car. This is an actual possibility for my son, by the way.
Viv
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