Making sense of RESPs

While I'm waiting for my baby son to make his appearance (overdue by a day now ... tsk tsk ... naughty baby), I'm spending my time baking, cleaning, reading, napping and planning for our family's financial future. I'm too huge to move around much, and I figure it'll be months before I'll be well-rested enough to think clearly about these things, so I'm trying to make my plans before the new baby-craziness sets in.

Anyway, among the financial issues on my mind is baby's college fund. Will and I would like our baby to avoid starting his working life with a pile of student loan debt, so we plan to set up an RESP (Registered Educational Savings Plan) pretty much as soon as the baby's born to take advantage of the government's 20% matching plan (up to $400 each year) and the fact that the RESP is sheltered from capital gains tax until the money is withdrawn. The idea is that when your kid withdraws the money for school, his income will be so low that he'll avoid paying some or all of the withdrawal tax.

RESPs are a bit tricky though, with all the rules. This is where the PFosphere steps in and clarifies things for those of us who are wrestling with complicated explanations on the government's and banks' websites.

Frugal Canadian has a great summary of the advantages and disadvantages of RESPs, and some info on what happens when you cash out:

Advantages

• Income generated on your contributions are tax deferred. This means, you do not pay tax on the income that's earned from the contributions while the funds are in the plan(up to 20+ years of untaxed growth)
  
• Up to $7,200 of free money --The Feds give a 20% Canada Education Savings Grant matched up to $400/year. Additional incentives available for low income families and the Province of Alberta.
  
• Payments of accumulated income are usually made to the child when they have little to no income(since they are a student) and therefore minimal taxes are due.
  

Limitations

• Contributions to an RESP do not result in a tax deduction on the contributors return. This is a common misconception and is NOT the case.
  
• Contribution limit is $4000/year for the beneficiary(aka. the child) to a maximum of $42,000 lifetime. This means that if you have grandparents that want to contribute you as a parent, have to share the $4000 each year. Overcontributions are penalized.

Vancouver Dad has done some of the calculations on how to maximize your RESP:

1. Contribute the maximum $42,000 to the RESP
2. Receive the maximum $7,200 in CESGs (Ed. note: Canada Educational Savings Grant - the 20% match I mentioned earlier)
   
3. Get the money into the RESP as quickly as possible to maximize the tax-free growth in the plan

To accomplish this, do the following: Contribute $4,000 a year for the first three years of the child’s life ($12,000), then contribute $2,000 a year up to an including the year in which the child reaches age 17 ($30,000 more, for a total of $42,000).

This strategy will both enable you to maximize the contributions to the RESP, and net you the full $7,200 in free CESG money from the government (18 years X $400 = $7,200). It will also get money into the RESP as fast as possible, allowing it the maximum time to grow.

Now the tough part is that you have to balance your RESP contributions with your own retirement fund, not to mention paying down mortgage and other debts. Depending on your income and spending/savings habits, balancing these needs could be tricky. But the last thing you want is to pour all your savings into your kids' college fund, but then have to rely on them to support both you and their own families if you didn't save enough for your retirement.

To save $4,000 a year, you'd have to bank $333 per month, which is difficult to do in the first year if you take the full allowable maternity & parental leave. I don't think we'll be able to contribute that much right away, but we will start with what we can afford and increase the amount we're saving when we're both back at work full-time. If we have more kids, I don't know that we'll be able to contribute that much for each of them. In that case, we will probably set our goal to save enough for each child to complete at least the first two years of a university degree or technical program at a community college; if they want to continue with further education, it will be up to them to get scholarships and/or save for the tuition.

Finally, speaking of RESPs, there's a bit of debate on whether to participate in a savings program like the Canadian Scholarship Trust. Canadian Capitalist recommends against participating in such a program, because there are high fees attached, and if you don't contribute every year you forfeit participation (unless you pay back the 'missed' fees later). Instead, Canadian Capitalist recommends going with something like TD Canada's RESP options, which allow parents to choose mutual funds, index funds or a self-directed investment program. According to CC, TD's eFunds offer some of the lowest fund administration fees in Canada.

My stepson is already set up with a group savings RESP plan (similar to Canadian Scholarship Trust I think) which we need to reactivate by paying the missed monthly dues. Given the six-year age difference between the kids, we will probably go for separate RESPs for them rather than combining it, as the money must be paid out by the oldest recipient's 21st birthday (baby will be 15 by that point). I'm leaning towards a TD RESP account, probably tied to the Canadian Index or a balanced moderate-risk mutual fund (though this should be converted to a steadier, more boring investment when baby hits his teens in case of a market crash).

According to Canadian Capitalist, it'll take a few months to get the necessary paperwork (birth certificate & social insurance number) to set up an RESP, so we have a little more time to make a decision.