I believe it was Pierre-Yves McSween who once said that when he saw a prestigious vehicle passing on the street, he would like to know the balance of the registered education savings plan (RESP) of the driver’s children.
I often think about this. The ratio of vehicle value to RESP account value would give us a good idea of the level of financial literacy of our fellow citizens.
This makes me realize that I don’t talk much here about the differences between the many registered accounts, such as the registered retirement savings plan (RRSP), the tax-free savings account (TFSA), the free savings account tax for the purchase of a first property (CELIAPP) or the RESP.
So this week, I’m going to talk to you about three ways to fund an RESP. I call them the RESP bronze, silver and gold medals based on their potential outcomes. Results that tell us as much about the RESP as about the power of compound interest.
As you probably already know, the RESP is a “box” that allows parents to leverage contributions and government grants to help finance a child’s post-secondary education.
The account can be opened from the year of birth. Then, when our little Mozart begins said post-secondary studies, almost two decades later, parents can recover their contributions. The growth of investments and subsidies will gradually be disbursed and imposed in the hands of the child. In fact, they will be little or not taxed, since adolescents or young adults generally have little income.
If your child becomes a TikTok influencer and does not pursue post-secondary education, the RESP can be transferred to another child. Otherwise, you will have to repay the government grants and the returns they generated, but you will keep your contributions and their growth – growth which can potentially be transferred to your RRSP.
To obtain the maximum subsidies, parents must contribute $2,500 per year per child. The federal government will add $500 per child, while the provincial government will add $250 per child.
The lifetime total of subsidies provided by governments is capped at $10,800 per child. This total is reached after a little over 14 years of contributing $2,500 per year.
After 18 years, and assuming a 6% return on investments, such an account could be worth around $100,000. In this scenario, $36,000 would come from parental contributions and $64,000 from performance and grants.
This is what I call the bronze medal of the RESP. While great, this approach leaves a lot of money on the table.
For what ? This is because the maximum lifetime contributions to an RESP account for a child is set at $50,000 – or $14,000 more than the $36,000 which gives entitlement to the full amounts of grants.
This “hole” is often untapped. However, even if they do not generate subsidies, these $14,000 could grow tax-free from birth until the time of disbursement. And growth will be forced into the hands of the child.
When your child is born, you therefore contribute $16,500 ($14,000 and the $2,500 from year 1) to the RESP. Then, you contribute $2,500 each year, until you have reached the limit of $50,000 in contributions.
This is the silver medal of college savings. With a 6% return, that’s around $139,000 after 18 years. Of this amount, $50,000 comes from contributions and $89,000 comes from grants and growth.
But there is an even more profitable strategy: invest the $50,000 at once when the child is born and contribute nothing after that.
By doing so, we are essentially saying goodbye to subsidies: we will receive $500 from Ottawa and $250 from Quebec the first year. But we won’t receive anything afterwards, since we no longer contribute.
How can not receiving subsidies be a good idea?
This is because the power of compound interest – which is simply interest on interest – crushes everything in its path, even checks from Quebec and Ottawa.
Over a period of 18 years, an investment of $50,000 could grow to approximately $145,000 if we assume an annual return of 6%. Of this amount, $95,000 would come from the growth of the initial amount and the $750 in grants.
And, let’s not forget: the parents get the $50,000 back. It is growth that will be imposed in the hands of the child.
This is the gold medal of the RESP.
I hear you protesting. Who has $50,000 to invest when their child is born? Probably not many people. In addition, this strategy is only advantageous if you have maximized your TFSA and RRSP contributions, and if you have paid your debts, etc.
But for a couple who starts saving in their 20s, it’s not out of reach.
For example, many people start having children later in life, at age 35 or 40.
A 25-year-old who saves and invests $40 per week and increases their savings by 10% each year would end up with $50,000 in the year they turn 35, assuming a 6% return. on its investments. For two people, that’s $20 per week per person to start.
These are not huge amounts. But it could yield huge results.
This is the power of compound interest.
Banks take advantage of compound interest to enrich themselves, especially when they lend money to people who want to drive a prestigious SUV.
And you ?
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