Tuesday, April 15, 2008

the smart R.E.S.P.

The Canadian government's Registered Education Savings Plan (R.E.S.P.) program is a great way for parents to save for a child's education. When used intelligently, the plan can really allow parents to give their child significant funds for their education while outlaying very little of their own money.

What do I mean by this? There are several ways to use the plan intelligently, but by 'used intelligently' I am referring to 2 practices in particular:

Invest fully, EARLY
Utilize the Universal Child Care Benefit (UCCB) and the Canadian Tax Benefit (if applicable)

By following these 2 simple tips, funding your desired portion of your child's education will be a breeze....much easier than first year chemistry anyway... Here's an example. Let's take two sets of parents, we'll call them the 'Smiths' and the 'Einsteins'.

On April 15, 2008 the Smiths gave birth to a bouncing baby boy named Darryl. But there were planes to catch and bills to pay, so the Smiths put off starting a nest egg for Darryl's education until 2020 when he was 12 years old. At that time they began putting in the maximum amount per year ($2,500) in order to still receive the 20% CESG grant ($500) that the government provides. The Smiths also did not use the $100 / month, that the government of Canada dolls out until the child is age 6 in the form of the UCCB, they hardly even noticed it....

Amount of their own money invested by the Smiths = $15,000
Amount Available for Darryl's Education in 2026 = $23,416
On the same day the Einsteins gave birth to a baby girl named Cheryl. Knowing the power of compounding, the theory of relativity, as well as the benefits of living below your means, the Einsteins began investing the $2,500 annually in the first year of Cheryl's life. Not only did they take this wise route but they also took the UCCB amount of $100 per month and used this as part of their $2,500 per year. The Einsteins had the Government of Canada giving them money upon money by having them match the UCCB to the tune of 20%. When Cheryl turned 6 Albert and his wife abruptly stopped all contributions.

Amount of their own money invested by the Einsteins = $7,800
Amount Available for Cheryl's Education in 2026 = $58,965

Both families invested for 6 years, but because the Einsteins invested early and utilized the monthly UCCB they were able to provide over $58,000 vs. the Smith's $23,416. The Einsteins pulled this off using half the funds that the Smiths used.

*rate of return used was 8%, assumed deposits made a beginning of each year.

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pitz said...

MG, unfortunately, many new families struggle heavily with credit card debt and balances with newborns.

At what interest rate do you personally feel is the 'break-even' point between contributing to a RESP with the CESG, and paying off the credit cards.

Any ideas?

Traciatim said...

Unless of course the Einsteins chose a group saving plan like CST, Heritage, USC, or whatever . . . cause then if they stopped 'the plan' steals most of their money. They also charge so many fees your money has a real hard time growing.

pitz . . . I'd say it's around 26% or so, but that doesn't include tax free growth. So you put in 100 bucks, the CESG puts in 20. Interest at 5% would gain 6 bucks . . . which is a 6 percent return on your original investment.

Of course, if you creditors are calling you because you can't keep up with your payments, I doubt you should be opening an RESP.

MG said...

pitz, good point. I would advise paying off credit cards first.

tri, 'steals most of their money'?

Akkei said...

Interesting. What would also be interesting is a comparison between two families, one like the Einsteins, and another one that takes the decision to rather invest this money in the new tax-free vehicle that will be available in Canada starting next year. Given that the tuition fees are deductible for the parents (but not if they are paid from a RESP if I am not mistaken), and given that these fees will likely be paid when the parents when they are in their 'prime revenue years' (and hence taxed at their highest taxation rate), I suspect that the advantage of contributing to a RESP are not as important as we may think for families that have substantial revenues.

MillionDollarJourney said...

Funny, i have a post about the song "cats in the cradle" coming up in the queue. :)

Great post btw.

pitz said...

akkei, do you mean deferring RRSP contributions to make RESP contributions? And then ramping up RRSP contributions later on in life when one is in the higher tax brackets?

All these plans are quite confusing. Personally, I think it would have been better policy simply to abolish the RESP altogether, and allow minors to participate in TFSA's, CESG and all. Why have another program that will be much more difficult to optimize for.

The reality for most Canadian families is that they don't have the cash to max out all three types of plans; RRSP, TFSA, and RESPs for their kids. But where is the money best put....

pitz said...

akkei, tuition is not deductible -- it only gives rise to a tax credit, the value of which is not a function of one's tax bracket.

traciatim, the problem using 26% is that CC debt, unpaid, continues to revolve and rack up interest. Whereas the 20% RESP top-up is one-time cash. Optimization depends on age, of course, and anticipated market returns, but I suspect that mg is right -- make sure you get rid of the credit card debt before making RESP contributions.

Now, here's another scenario to chew on: should a family make a contribution to a larger downpayment to avoid expensive CMHC insurance, or should they take the expensive CMHC insurance, and make RESP contribution? I suspect that augmenting the downpayment will result in a better long-term financial position compared to the RESP, even if the CESG is foregone.

Sometimes I think you need to be an engineer or have a math degree to figure this stuff out, lol. (I have both, actually, and still find it confusing).

Traciatim said...

@MG, I guess calling it stealing is a little bit of a stretch, but every group plan I see works on a 'per unit' basis. So in my example when I was young and stupid I signed up with CST and purchased 10.5 units for my newborn daughter. Since I have 10.5 units their enrollment fee was $2100 dollars. These get refunded at the ent, but not if you leave early. So if you leave they keep a rather large chunk of money, hence the 'steal your money'.

dividenddollar said...

Another good example of the power of compounding!

Ivo said...

In regards to CST, Heritage, etc RESP plans...

1) You _can_ purchase units up front, rather than subscribe to their "lease to own" plan. This allows you to back out at any point.

2) Particularly in the event you have more than one child, a self-directed family RESP is the way to go. Several benefits including joint "contributor" status shared between wife and husband means either can withdraw funds after the requisite 10 year period has elapsed. Assets within the plan can be shared between childern - at your discretion. *THIS is a big knock against CST, Heritage, et al. Education Assistance Payments (EAPs) are predefined on their terms and schedule - not yours. An RESP can be held intact for 26 years - no strict need to empty the account and draw out the entire income over a four year university degree. The mechanics are a little tricky, but worthy of understanding upfront. As noted, in the final analysis, if you're looking at 10k plus investment into the plan, I'd recommend self-directed family RESP.