An RESP strategy that works

In my last column, I wrote about the extraordinary unused potential of registered education savings programs (RESPs). I also discussed in general terms the importance of helping clients take advantage of federal and provincial grants and incentives to maximize tax sheltered savings for their children’s or grandchildren’s higher education. RESPs should appeal greatly to investors, considering that the various incentives available for these plans can produce a return on investment of as much as 20%. And since the RESP market could conceivably grow to as much as $340 billion, there’s an obvious attraction for financial advisors.

This time, I’m going to revisit a simple RESP savings strategy that is used by many parents and grandparents and compare it to a strategy that is less common. The more common, simple strategy is based on the notion of making sufficient annual RESP contributions in order to maximize use of the key federal and provincial (where applicable) incentives of these plans, such as the Canada Education Savings Grant (or CESG).

CESG revisited

As I mentioned last time, the CESG is geared to income. For families with net income of $40,970 or less, the basic grant will be up to $200 on the first $500 saved in an RESP, and as much as $400 on the next $2,000 saved. For families with net income of more than $81,941, the basic grant drops to $100 on the first $500 saved. Regardless of family income, the lifetime limit for the grant per child is $7,200. There are special rules that apply to children between the ages of 15 and 17, but in essence, the CESG is rather like free money. More than three million Canadian children have already benefitted.

This basic strategy requires that clients have or will develop the financial discipline to make it work by making annual contributions, however, clients can manage their cash flow by making regular weekly or monthly plan contributions. The reward for this diligence is that most, if not all, of a child’s post-secondary education costs will be met. This is a solid strategy that works for many parents and/or grandparents, but I’m going to suggest an alternate approach to this strategy, that may work in other less common situations.

Strategy begins at birth

A colleague of mine recently gave birth to a boy, the first grandson in a very pleased and very happy extended family. My colleague’s parents seem especially pleased, although it’s clear their present joy is hardly preventing them from being farsighted. They feel strongly that they want to make sure that this newest addition will be financially prepared for a higher education. And while they could adopt the simple strategy discussed above, they have considerable financial means and could immediately set aside the maximum $50,000 lifetime contribution for their new grandchild. Emotionally, the grandparents favour the large upfront contribution, thus knowing that their grandchild’s post-secondary education has been provided for; however, they see no reason to forego the benefits of the CESG. The one worry they have on this score is that they may not live long enough to obtain the maximum CESG grant of $7,200. It will take slightly more than 14 years to reach the maximum, based on the proportion of contributions that they will be allowed to claim.

This is where you can be of great help as a financial advisor. While the grandparents will naturally rely on you to provide sound advice on ways to invest the money they contribute to their grandson’s RESP, you can also provide additional value by showing them the different approaches they can use to achieve the same result. Of course, the grandparents could also consider using their own TFSAs, an ‘in trust’ account or a formal trust to set aside funds their grandson’s education, but this article focuses on two options using an RESP.

So how can the grandparents and their family benefit most from the tax-advantaged growth offered by an RESP? Should they simply put the full $50,000 in the RESP today and forego nearly all of the available CESG money, or should they contribute gradually and gain the maximum CESG benefit? These are questions that you can help answer.

Two options, one destination

To do this, let’s take a closer look at how the grandparents in our strategy example can use two methods to amass the same amount of savings for their grandchild’s higher education.

In option one, the grandparents decide to set up an RESP and contribute the $50,000 lifetime contribution limit immediately. They will receive the maximum CESG grant of $500 for the first year, but they will forego the grant thereafter.

In option two, the grandparents are more hopeful that they will see their grandson grow up. They decide to take a more gradual approach to reaching the maximum lifetime contribution, putting $16,500 in the RESP and $33,500 in a non-registered account in the first year, and then transferring $2,500 in each of the next 13 years. They make a final $1,000 transfer in year 15. Over those 15 years, they will receive CESG payments that allow them to reach the lifetime limit of $7,200. The total funds set aside up front is $50,000 and the total RESP contributions over time is $50,000 which structures this option to be comparable to the option above.

Using a basic calculation, the average annual rate of return needed to break even in the two scenarios is 4.43%. After 17 years, about the time that the grandson will be completing secondary education, the plan in either option will have a total savings of about $105,000.

If the annual rate of return on the RESP is likely to be more than 4.43%, it would make more sense to take option one and invest the full $50,000 immediately and forego the CESG after year one. If the projected rate of return is likely to be less than 4.43%, the gradual contribution approach of option two with its maximization of CESG payments is the better choice.

I add a caveat that this analysis is based on straight forward assumptions; it could be made more complex by taking into account factors such as inflation and changing annual market action.

The advisor makes the difference

My colleague’s parents were grateful that the advisor took the time to look at the two options. So what did my colleague’s parents actually do for their new grandson? They contributed $50,000 to the RESP right off and went with option one, thankful for their advisor’s suggestion to establish the RESP and felt confident that, with her advice, they could exceed a 4.43% rate of return. Not everyone has the resources to do this, but their story underscores two important lessons. Compounding works, and sound advice can leave clients and their loved ones much better off.