Three common questions on Registered Education Savings Plans (RESPs)
Last week, I spent some time talking about all of the benefits of Registered Education Savings Plans (RESPs). This week, as a result of some questions from readers, I would like to follow up with three frequently asked questions on RESPs.
Are RESPs the best way to save for children’s education?
RESPs are not the only way to invest for future education. There’s no question it is one of the most attractive options given the Canada Education Savings Grant (CESG) from the government. Some parents and grandparents elect to use other alternatives for savings like informal trust accounts. Informal trusts are popular because the money does not have to be used strictly for education purposes. The money can be used to start a business, buy a house, used for travel after school or for education. Quite frankly, it can be used for anything. Naturally with informal trust accounts, the government does not kick in anything and depending on how you structure the investment, taxes may have to be paid on the growth each and every year. With both the RESP and the informal trust account, the contributions are not tax deductible like RRSPs.
What if the child does not go to school?
Before the changes to RESPs in 1998, the RESP was very restrictive in terms of options if the child did not go to school. Today, the RESP rules provide more flexibility in these situations.
Firstly the RESP funds can be transferred to a sibling used for their post secondary education. The replacement beneficiary must be connected to the subscriber by blood or adoption. The replacement beneficiary or any of the other beneficiaries can use the CESGs paid into the family plan as long as they are under the age of 21.
If the funds cannot be transferred to another sibling, then the subscriber (usually parents) can take back all of the original contributions and the government takes back all of the CESG put into the plan. The only thing left in the plan is the growth from the contributions by the subscriber and the government. The subscriber can transfer up to $50,000 of this growth money in to their RRSP or a spouse’s RRSP as long as they have enough RRSP contribution room. If they do not have enough RRSP contribution room, this money will be fully taxable at the subscriber’s marginal tax rate. In addition, there will be a penalty of 20 per cent on the withdrawal amount. For example, if the subscriber is in a 40% tax bracket, the accumulated income would be taxed at 60%.
How should you invest RESPs?
There are many investment options like GICs, mutual funds, stocks, bonds, etc. It is important to shop around for the right RESP investment just like any other investment. Typically the subscriber (parent) makes all the investment decisions on behalf of the beneficiary (child). From my perspective, whenever you are investing money for someone else, it is important to use more discretion and prudence.
Some people will argue that when the children are young, you should invest in stocks and equity mutual funds for the long term despite the risk. The problem is I have seen many accounts where subscribers have put money into high-risk tech funds, for example, only to lose the free money from the government and almost half of the original contributions. I think that being more conservative is prudent especially since the government puts in the 20% CESG. That’s kind of like making a 20% return without taking any risk to begin with. Whatever the case may be, think twice before taking too much risk when investing RESPs.
According to statistics Canada, it is estimated that by 2019, the total cost of a four-year university education will be $74,000 and a three-year college education will total $45,000. Now that’s motivation enough to start saving into the RESP.