The BasicsWhen you set up an RESP, you register two individuals under the plan:
- The contributor (you) is the subscriber
- The future student is the beneficiary
- Provided that the beneficiary attends a university or college, withdrawals from the plan are taxed at the marginal rate of the beneficiary, not the subscriber. Since the beneficiary, as a student, should be in a low tax bracket, they will pay very little tax on these withdrawals
- The subscriber has already paid tax on the contributions, so only the growth in the investments is taxable. Combined with the first point, this means that RESPs can provide over 20 years of nearly tax-free growth
The Big "If"The big question with RESPs is, what happens if the child doesn't pursue post-secondary education? In this case, you "collapse" the plan, meaning that you, as the subscriber, close the account and withdraw the funds. Since you can have over 20 years of investment growth in the plan, there will clearly be some taxes to be paid. Here's the rundown:
- Your contributions are not taxed, since you made them with after-tax dollars
- You must refund any CESG that you received, immediately knocking up to $7,200 off your investment growth
- You must pay a 20% penalty on your investment growth (excluding CESG)
- You must pay taxes on your investment growth (excluding CESG) at your marginal rate
An ExampleSuppose you contribute the $50,000 maximum, receiving the $7,200 CESG maximum, and over the years your investments grow to a total of $100,000. If the beneficiary attends university or college, then they have access to $57,200 in tax-free money, plus $42,800 in investment returns that, if used for education, will be taxed at their (low) marginal tax rate.
If the beneficiary does not pursue post-secondary education, then the plan must be collapsed, and the funds revert to the subscriber. If the subscriber's marginal tax rate is 40%, then they will have to pay the following:
- 0% tax on $50,000 contributions = $0
- $7,200 in refunded CESG
- 20% penalty on $42,800 investment growth = $8,560
- 40% taxes on $42,800 investment growth = $17,120
- Total paid = $32,880
- The 20% penalty is meant to offset any investment growth that you realized based on the CESG matching. Since your contributions were topped up by 20% each year, 20% of your investment growth is essentially due to this grant. So, having to pay back the CESG plus 20% of your returns makes sense
- The RESP can be looked at as a sort of "education insurance", where you pay an annual premium so that you have "coverage" in the event that the beneficiary pursues post-secondary education. Unlike most insurance policies, however, you get back all of your contributions at the end, with interest, if the plan is collapsed
- The $17,120 in net investment returns in the example given above should still be better than inflation, so even though you paid a big chunk to taxes, your contributions have still more than kept their value over time
- You were essentially willing to "gift" all of your contributions to the beneficiary anyway, so getting back your nominal contributions is a pretty nice consolation prize
The VerdictFor me, it really comes down to this: an RESP is a way of saying to a child, "I'm willing to help you out if you decide to pursue post-secondary education." If the child takes you up on the offer, then they have a great resource to help them through their education. If not, you've passed up some potential investment opportunities, but you more than recoup your contributions, and you know that you were there to support the child. There's nothing to stop you from giving them some of this money anyway, if that's what you want to do.
I'll be looking into setting up RESPs for some of my young relatives over the next couple of years.