Thursday, February 7, 2008

Looking into RESPs

The Loonie clan has seen a number of new additions recently, with births and pregnancies abounding. As a result, I've been thinking about RESP options, and decided to learn a little more about the workings of this plan. I've written briefly about RESPs in my Loonies And Savings Plans post, and other Canadian bloggers have posted great guides to RESPs, so I won't be delving too deeply into the intricate workings of these accounts. Instead, I'll look at a few of the rules, and lay down my decision on participating in the plan.

The Basics

When you set up an RESP, you register two individuals under the plan:
  • The contributor (you) is the subscriber

  • The future student is the beneficiary
The subscriber can contribute after-tax money to the plan, up to a lifetime limit of $50,000 per beneficiary. In contrast with RRSP contributions, the subscriber does not receive a tax deductions for any RESP contributions. However, the plan does have a couple of tax advantages:
  • 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
In addition to being a fairly tax-efficient way to save for a child's post-secondary education, there is the additional benefit of the CESG, which matches 20% of subscriber contributions, up to an annual maximum of $500 and a lifetime limit of $7,200. The CESG matching contributions count as investment growth, and are not taxed when withdrawn by the beneficiary. This represents an immediate tax-free 20% return on the first $2,500 in annual contributions.

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
That's a pretty big tax hit to look at, but there are many factors to consider.

An Example

Suppose 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
This leaves the subscriber with $67,120 ($50,000 contributions plus $17,120 growth) out of the $100,000 that was built up in the plan. The 20% penalty, combined with the loss of favourable tax treatment of investment income, result in a huge tax hit to the subscriber in the event of a collapsed plan. However, there is some rationale behind these penalties:
  • 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 Verdict

For 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.


Four Pillars said...

Great post and thanks for the link. It's very generous of you to set up RESPs for your relatives.

I wanted to add a couple things about collapsing the plan if the child does not go to school:

1) If the subscriber has rrsp room they can transfer the AIP (growth) portion of the RESP to their rrsp and avoid the 20% penalty as well as they can then withdraw the money when it's more convenient from a tax perspective.

2) You have 26 years from when the account is setup so for a lot of people it's not unreasonable to be retired by the time 26 years go by. If that's the case then you can manage the RESP collapse like a retirement account and reduce taxes accordingly. Another situation might be someone who has a flexible pay schedule (ie self-employed) or can take a year off - they could collapse the RESP in a year where they don't have much other income.


Loonies And Sense said...

@Mike: Thanks for the comment. These points make the "downside" less significant, as they further lessen the tax blow on plan collapse.

As far as generosity, I'm not talking about a huge contribution, probably something in the neighbourhood of $50-100 per month, and only once I've righted my own ship (i.e. once my revolving debt is paid off).

I don't want my relatives to use their education savings to support poor Uncle Loonie! :)

Canadian Capitalist said...

Thanks for the link. Also, the government keeps tinkering with the RESP rules. So, who knows what the rules will look like 10 or 15 years from now.