RESP’s: The Ground Rules

Though one might think a government introduced education savings tool would be structured to be simple to understand, Canadian Registered Educations Savings Plans (RESP’s) are instead one of the most complex tax advantaged accounts in Canada.

God forbid the Canada Revenue Agency (CRA) make saving for your kids education straightforward!

Annnnnnnyhoo.

Irrespective of my views on the current value of post-secondary education , or my firm belief that young adults should take on the financial responsibility of paying for at least a portion of their own schooling, I am a big proponent of utilizing RESP’s to your (and your child’s advantage.) The primary reason being that if there is even a slight chance that your child will pursue post-secondary education for a specific and valuable purpose, it is absolutely worth setting up an RESP not only for the free government money, but also the potential tax advantages down the road.

After all, whenever the government is willing to hand me back some of my money, I am definitely on board.

But first, a quick warning. RESP’s are a Canadian specific savings tool, so for my friends from elsewhere around the globe, my apologies in advance, but you may not get a lot out of this post other than satisfying your curiosity of what government incentives we have available North of the 49th.

So What Exactly is an RESP?

If you’re not familiar with them, RESP’s are the Canadian Government’s effort to provide a tax-advantaged option for saving for your children’s post-secondary education costs.

In order to apply for a RESP for your child, they must be under the age of 21, a resident of Canada, and have a valid Canadian Social Insurance Number. If you haven’t already, you can apply for a SIN for your child simply by submitting an application along with a copy of your own SIN, and proof of your child’s residency/citizenship.

RESP’s act much in the same way as a Registered Retirement Savings Plan (RRSP), or Tax Free Savings Account (TFSA), in that they are merely an account that can be opened at a participating financial institute and are subsequently registered by the institute with the CRA. Once an RESP is established, the financial institute where it is held will report to the CRA all contributions, grants, and investment income held or withdrawn from the account.

Although it may seem obvious to avid investors, it is important to note that the RESP itself is not an investment. It is merely an account in which you can hold funds, with the option to place them into a wide variety of investments. So if you set-up an automated direct deposit into an RESP for each of your children, but you don’t manage the funds by investing them, they are sitting within the RESP in cash. Although you will still be eligible to collect the government grants as a result of the contributions to the RESP, if you don’t take the additional step of investing the money, both your contributions and the grants will sit there being slowly eroded in value by inflation.

Why Use An RESP?

A substantial benefit of utilizing an RESP is that contributions to the account are matched by the Canadian Government with an incentive known as the Canada Education Savings Grant. The grant is paid into the RESP at a rate of 20% of your annual contributions, up to a maximum annual grant amount of $500, (or $2500.00 per year in contributions).

The maximum grant amount for each individual RESP recipient is capped at a lifetime total of $7200, (or $36,000 in contributions).

If you are late in the game at starting an RESP for your kid(s), don’t stress it, you can recover the grant money retroactively by increasing your annual contribution amounts until the full amount has been captured.

Depending on your province of residence, you could also be eligible for additional grant money. For instance, in BC, so long as you have an open RESP for your child, and both you and your child are residents of BC, they are eligible for an additional $1200 British Columbia Training and Education Savings Grant. No additional contributions are required to obtain this grant, it truly is free money, so everyone should be claiming this grant regardless of their financial circumstances.

Strangely, you can only apply for this grant for your child when they are between the ages of 6 and 9, so it’s an important one to pay attention to and ensure you snag the extra free cash when they turn 6 in order to allow the most amount of time to benefit from investment growth.

Another significant benefit of the account is that the investment growth of both the contributions and the grant money, are tax deferred. Meaning that the investment’s within the account can accumulate growth, and that growth can later be withdrawn at the recipients tax rate as opposed to the contributors tax rate. Because most post-secondary students are in low income brackets, it’s very likely that the investment growth will be taxed minimally, if at all.

This is another reason you do not want to let your savings sit as cash within the RESP. You’ll miss out on not only the investment growth, but the substantial tax savings down the line.

Limitations of An RESP?

If you have dreams of saving a few hundred K for your kiddo’s Ivy League education, unless you make some miraculous investment decisions, this savings vehicle alone isn’t going to do the trick. With a lifetime contribution limit of $50,000 per recipient, there are definitely limitations to what the RESP can offer.

And to be clear, this means all contributions made for a recipient. While it doesn’t include either the grant money (CESG or BCTES), or any accumulated investment growth, it does include any contributions made by Grandma and Grandpa, or any other family member or friend who decided to contribute to your kids future education.

If you do go over that $50,000 ceiling, you will be liable for a taxation penalty of 1% of the amount exceeding $50,000 for each month that you remain in excess of the limit. And while there are avenues to appeal this taxation if the limit was breached in reasonable error, it’s best to be aware of the limit and communicate with anyone who might be making contributions on your children’s behalf to make sure that doesn’t happen.

This is particularly relevant for divorced parents who each have a separate RESP plan open for their child(ren).

Available Plans

There are two options when it comes to the structure of the RESP plan.

You can elect to have a non-family plan (or individual plan), which really just means the recipient or beneficiary can be anyone. Related to you or not. Only one person can be named as the beneficiary or recipient of money held within this plan.

You can also elect to open a Family RESP plan which allows you to house funds for multiple children under one plan. However, to be eligible for a family plan, each named recipient or beneficiary must be related by blood or legal adoption to each living subscriber(s) of the plan. (Note* this rule was introduced as of July 14, 1990, and anyone who had a family plan prior to that is grandfathered under the old rules).

While a great option, Family RESP plans can also create a lot of problems for people, because often parents assume that the funds contributed into the plan can be used and/or divided between the children however they may be required. On the contrary, any contributions you make to the plan must specify which recipient they are being contributed towards. A lot of people get caught here by simply setting up a monthly direct deposit of a lump sum amount, without identifying how much of that lump sum goes to each child. In those situations, all of the the money will end up being earmarked for one recipient, while the others will have a zero balance.

If you find this confusing, you are mot alone, but try thinking of it this way. The RESP account is a house. Within that house you have a separate bedroom, or sub account, for each of your children. Your contributions may automatically go into that house, but if you don’t specify exactly which bedroom you want them to be stored in, they will all default to only one bedroom.

While not well understood, family plans do make it easier to transfer unused RESP balances from one child to another and be exempt from the typical $50,000 ceiling limits imposed, so long as the receiving child is under 21 years of age, and the contributor is the parent of both the former and new beneficiaries.

This is important to note, because in cases where there are mixed families with step-children, you likely want to have only the respective biological parent listed as the contributor of the RESP, unless the step-children are legally adopted, in which case the exemption would also apply.

In our experience, many financial institutes are not well versed in the nuances of the family plans and how the differ from non-family plans, so it is best to self-educate on these products rather than relying on your banks Financial Advisor (aka salesperson).

Investing Within RESP’s

So once you’ve got everything set up with your RESP’s, and you’ve arranged your contribution schedule, the next step is to invest the funds housed within the RESP.

The investment options available within an RESP mirror those of RRSP’s/RRIF’s/TFSA’s and other similar accounts, in that they must be considered a “qualified investment” under the Income Tax Act. Qualified investments consist of fixed income and equity investments, such as bonds, GIC’s, ETF’s and the like.

Similar to an RESP, the desirable structure of your investments within the RESP is dependent largely upon the age of your child. Weighting the investments more heavily to equity investments in the first half of your child’s life when there is a longer time frame to grow and recover from market volatility, with a slow transition to lower risk investments as your child nears post-secondary age is generally the recommended approach. Of course this will heavily depend on your overall risk tolerance and investment knowledge.

If you have multiple children, you should ensure that their individual funds within the RESP are appropriately invested for their relative age, and not just simply mirroring each other.

When It’s Time to Collect

A beneficiary can begin to collect funds from the RESP in the form of both the contributions made to the RESP as well as Education Assistance Payments (comprised of the CESG, any provincial grants where applicable, and the investment growth). They are eligible for these payments once they are enrolled in a qualifying educational program, or 16 years of age and older and enrolled in a specified educational program.

A qualified educational program is defined as one which is at a post-secondary level, lasts at least 3 consecutive weeks, and requires the student to spend 10 hours or more completing program work each week.

A specified educational program has the same post-secondary level and duration thresholds, but requires only 12 hours or more of work per month.

Because contributions are after tax money to begin with, there are no rules on the amount and frequency to which contributions can be paid out to the recipient when they are enrolled in an eligible post-secondary program. Nor are there any tax implications when the contributions are paid out. However, the duration of attendance of the course, and hours per month do dictate the eligibility for the amount of the maximum EAP’s during the first 13 consecutive weeks of the program. So if the maximum EAP’s don’t meet the expenses incurred, you can utilize the contributions to top up as needed.

It is important to note that the EAP’s can be used for any “reasonable” expenses incurred to facilitate the pursuit of post secondary education. Not only does this include tuition, and books, it can also include rent, associated bills, school supplies (laptop etc). So long as you or the recipient can demonstrate that the expense was incurred to further the pursuit of their post-secondary education, it will generally be determined by the financial institute holding the RESP and responsible for the assessment of expenses, to be reasonable.

The withdrawal ratio of the EAP’s to contribution dollars is also an important consideration. For instance, if your child plans to have a job in the first years of their post-secondary education, but not in their final years, they may elect to withdraw largely EAP’s in the years when their income (and tax bracket) will be lowest, since they won’t be taxed on withdrawals of contributions, but will be taxed on the EAP’s at their relevant income bracket.

Deferring contribution withdrawals in favour of EAP’s also applies if your child’s education and associated expenses will cost less than the savings within the RESP. By utilizing the growth and grants first, the remaining contributions can be returned to the contributor or paid out to the recipient without penalty or tax implications.

What if My Kid Doesn’t Go To Post-Secondary

There’s a lot of rules governing the pay out of funds within the RESP if your child doesn’t use the money for post-secondary education, so the answer is really dependent on a case by case basis. The extensive rules governing this area primarily ensure people aren’t misusing the RESP’s in a manner for which they weren’t intended (ie: tax deferral for the contributors gain).

But generally speaking, if you have other children with RESP’s that haven’t been maxed out, you can transfer the contributions, growth and grant’s to that child. So long as the contributions and grants do not exceed the maximum allowable for either category ($50,000 contributions, $7200 CESG and any available provincial money), or the new beneficiary is eligible for an exemption which allows the limit to be exceeded as a result of a transfer.

This exemption would apply if the contributor of the RESP is related by blood, legal adoption, or is a parent to both the former and new recipient, and the new recipient is under 21 years of age.

If you don’t have any other children to transfer the funds too, you will have to do something with the money by the time the named recipient turns 35. In these cases you can close the RESP, but will have to pay back any grant money received, along with any growth related to those grants. The remainder can be withdrawn by the contributor, but the growth would then be subject to taxation at the contributor’s current tax rate.

Given that most Freedom seekers will have achieved Financial Freedom at this stage, it likely won’t be all that bad given that you will no longer be at a high tax rate yourselves.  Alternatively, if you still happen to have room in your RRSP at this stage, you can also transfer the investment growth directly into your own RRSP, tax free.

Summary

As I mentioned at the beginning of the post, RESP’s are certainly one of the more complex registered accounts and the governing rules would take a whole series of posts to cover in detail. But my hope is that this post has adequately covered the basic’s of RESP’s, and briefly highlighted some area’s you may want to look into further should they apply to your situation.

When it comes to tax related topics, I personally prefer to go straight to the source, and would therefore encourage anyone looking at RESP’s to familiarize themselves with CRA’s website on the topic.  CRA’s FAQ page, is a great place to start.

That said, if you’ve opened RESP’s for your kids largely to take advantage of the free government grants, one of the easiest no-muss no-fuss ways to maintain it is by setting up $100 bi-weekly deposits (or similar) that go directly into each child’s RESP.

This will amount to a total annual contribution of $2600.00 annually per child, ($49,400 over 19 years), and will get you every penny of the governments $7200 grant (Don’t forget to apply for your provincial grant as well!), and essentially max out the eligible room for deferred taxation of investment growth. From there, you can then schedule bi-weekly automated deposit’s of that $100 into low-fee ETF’s, operating on a dollar cost averaging model.

Whatever you decide to do from an investment perspective, do try to open an RESP as early as possible in order to allow your child the benefit of the investments having the most time to work and grow. While there are a substantial amount of rules and limitations to the RESP plans, they can serve to provide a phenomenal leg up to your kids if they choose to pursue post-secondary education down the road.