The “new normal” of COVID-19 makes it difficult to focus on anything but the here and now — especially if you have young children at home. So, it’s understandable if saving for your kids’ future education is not top of mind. Thankfully, there is a simple tool to help you get started, called a Registered Education Savings Plan (RESP). And (bonus!) it also includes free money from the government.
How does an RESP work? Here’s everything you need to know, including how you can access those free funds.
What Is An RESP?
An RESP is a type of tax-sheltered investment account, like a Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA), but specifically for the purpose of funding a child’s post-secondary education or training. That means you won’t pay income tax on the earnings generated on cash or investments held within an RESP, including bank interest, dividends, capital gains, or any other investment income.
How Does RESP work?
You open an RESP account as the plan sponsor and name a beneficiary — usually a child or grandchild. You can contribute as much as you like to an RESP each year, but there’s a lifetime limit of $50,000 per child.
As an incentive for parents to save for their children’s education, the government also provides a 20% Canadian Education Savings Grant (CESG) on annual RESP contributions, up to $500 annually and $7,200 in total per child.
Once the child attends an eligible college, university, or apprenticeship program, he or she can access the money in the RESP, with certain stipulations, as we explain later on.
Why Should You Open an RESP?
There are several excellent reasons to open an RESP:
- The government will give you free money. As mentioned above, you can get up to $500 a year (lifetime limit of $7,200) in CESG money per child. There is also additional assistance for low-income families (with a combined net income less than $47,630) in the form of Canada Learning Bonds, which pay up to $500 in the first year and $100 in subsequent years, to a maximum of $2,000.
- Your investments will grow tax-free. Because you don’t pay income tax on the investment income within an RESP, those earnings will compound over time to maximize your returns.
- Withdrawals are tax effective. A portion of the funds (investment earnings and grants) are taxable when students eventually start drawing from an RESP, but since students typically don’t earn much and can claim the tuition tax credit, their tax bill could amount to $0.
- You are investing in your child’s future. Any amount of money you can provide to help with a child’s post-secondary education is that much less they’ll need to borrow to fund their dreams.
How to Invest in An RESP?
Before you choose where to open your RESP account, be sure to compare the administrative and investment fees the provider charges. Banks typically charge the most, while the best discount brokerages in Canada offer the lowest fees. Questrade gets rave reviews because you can build your own RESP investment portfolio at a low cost, especially since you get $50 in free trades when you sign up.
For those who are new to investing or prefer to take a more hands-off approach, one of the best robo advisors in Canada will create and manage a portfolio of low-fee ETFs to meet your needs. Wealthsimple is our top choice because it offers competitive pricing, an easy-to-use platform, and access to human advisors. Bonus Offer: Get a $100 cash bonus when you open your first Wealthsimple Invest account with $1,000!
Also, Canadian robo advisor Justwealth even has a unique RESP service called Education Target Date Portfolios, which automatically aligns your investment allocation with the year your child will begin his or her post-secondary studies. Another bonus: Young and Thrifty readers will receive a cash bonus of up to $500 when they open a new Justwealth account.
Once your RESP account is open, you can start depositing money and investing it to make the most of the tax-sheltered compound returns. You’ll want to choose a broad array of assets (stocks, bonds, GICs, etc.) diversified across regions (Canadian, U.S., international) and sectors (consumer, energy, healthcare, financials, technology, etc.). You can also invest in exchange traded funds (ETFs), which allow you to easily diversify your money across an entire market.
If the child named in your RESP is young, you should have a more aggressive portfolio weighted toward stocks, since these offer better returns and you have lots of time to weather any market volatility. When the child gets closer to post-secondary pursuits, you should move your money into lower-risk fixed-income investments, such as bonds, GICs, or high-interest savings accounts, because if there’s a downturn you won’t have time to let markets recover before you start tapping into those funds.
RESP Withdrawal Rules
Once the child named in the RESP is enrolled in an eligible college, university, or apprenticeship program, he or she can begin withdrawing funds to pay for any education-related expenses, including tuition, books and housing.
Because you’ve already paid income tax on your original RESP contributions, your child won’t have to pay tax when withdrawing those funds. These withdrawals are called Post-Secondary Education Payments (PSE).
But since you never paid tax on the grant money you received or the income earned on your RESP investments, those withdrawals (called Education Assistance Payments, or EAP) are considered taxable income for your child. Having said that, most students have limited incomes and can claim the tuition tax credit, so they probably won’t end up paying much tax, if any.
As for how much a student can take out of an RESP each year, there are no limits on PSE withdrawals. For full-time students, EAP withdrawals are limited to $5,000 during the first 13 weeks of study only, after that there are no restrictions. For part-time students, EAP withdrawals are limited to $2,500 for every 13-week period.
RESP vs. RRSP
In an ideal world, we’d all have enough money to max out our RRSPs and contribute enough to RESPs to qualify for the annual $500 CESG per child. In the real world, however, you’ll probably have to decide how much of your savings you want to put toward an RRSP vs. RESP account.
There are arguments to be made on both sides. Some say to prioritize your RRSP, since your kids will have access to low-interest loans to fund their schooling, while you can’t easily borrow money to fund your retirement. Others point out that your kids are probably going to need money to pay for school long before you’re retired, which means you’ll still have lots of time contribute to your RRSP later.
But, if you look at in purely financial terms, the 20% in grant money provided on eligible RESP contributions is pretty hard to beat. While an RRSP contribution may save you more than 20% in taxes (depending on your tax bracket), the tax that you’ll pay when you take out the money in retirement will offset some (or all, depending on your total retirement income) of those savings.
Bottom line? If you have kids, try to contribute $2,500 to an RESP annually for each child, so you can get all the free CESG money you can. Anything beyond that amount can go toward your RRSP. Conversely, if you’re making an RRSP contribution large enough to provide you with a tax refund of at least $2,500 (or $5,000 if you have two kids, $7,500 if you have three kids, etc.), you can then channel your refund into RESPs and still max out your CESG benefits. You may also want to consider whether a TFSA or RRSP works better for you.
RESP vs. TFSA
As explained above, an RESP should be your first choice for funding a child’s education because of the grants (aka free money) the government provides. Once you’ve hit the lifetime maximum grant total of $7,200 per child, however, investing in a Tax-Free Savings Account (TFSA) is just as good. You’ll not only shelter your investment income from tax, but there are no restrictions on how or when you can withdraw the money. Read more about The Best TFSA Investments in Canada.
However, if your intention is to use those investments to pay for a child’s education (as opposed to just growing your money to the best advantage regardless of how you plan to spend it) there are a couple of caveats to be aware of. First, the TFSA must be in your name and you must have contribution room available since children don’t start accumulating their own TFSA contribution room until they are 18. Second, you’ll need to be disciplined enough to leave that money untouched—potentially for decades—so it will be there when your child needs it. This can be challenging given how easy it is to withdraw money from a TFSA without penalty.
What About Group RESPs and Scholarship Trusts?
Despite the “RESP” in the name, Group RESPs are actually a very different financial product from the RESP accounts discussed above and are therefore more accurately described as scholarship trusts.
Scholarship trusts pool your RESP contributions and CESG payments together with those of other members of the trust. A plan manager then invests those funds in low-risk assets, such as GICs, bonds, or fixed-income ETFs.
While some of the regular RESP rules—such as the lifetime contribution limits and CESG allotments—apply to scholarship trusts, they usually come with their own additional rules as well. For example:
- You must agree to contribute to a scholarship trust on a set schedule until the plan matures (which could be as long as 18 years). If you can’t make all your payments on time, you’ll be charged penalties or kicked out of the plan.
- If you’re ousted or choose to exit the plan before it matures, you will lose some of your original contributions (which go toward enrollment fees) and some or all of your investment earnings.
- The amount of money available to your child when he or she attends school is dependent on the number of other investors in the scholarship trust, how much they have invested, and the number of students who are withdrawing from the plan at the same time.
- There can be other fees and restrictions with scholarship trusts. For example, part-time students may be ineligible to receive payments from a scholarship trust, even though they can withdraw funds from an individual or family RESP.
Some parents prefer the rigid contribution schedule that a scholarship trust mandates, since it keeps them disciplined with their savings. Before you go this route, however, be sure to get and review the scholarship trust’s prospectus—including all the enrollment fees, penalties for withdrawals, and other restrictions—so you know exactly what you’re agreeing to and what the risks might be as compared to an individual RESP.
If you’re a parent and haven’t started investing in an RESP, there’s no time like the present. The recent market downturn caused by the coronavirus pandemic has provided an excellent buying opportunity for investors, effectively creating a discount on assets.
If you’ve lost your job or cannot work due to COVID-19 lockdown, it’s an especially good time to open an RESP because low-income families (with annual after-tax earnings less than $47,630) are eligible to receive hundreds of dollars in Canada Learning Bonds, even without making any contributions.
Regardless of income, if you contribute to an RESP the government will kick in an extra 20%, up to $500 per year, in Canada Education Savings Grants. And, if you start investing online using a discount brokerage like Questrade or robo advisor like Wealthsimple or Justwealth, you’ll not only save money on taxes by sheltering your investment income within an RESP, you’ll also save big time on investment fees.
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