A Registered Education Savings Plan (RESP) is a tax-advantaged account designed to help parents save for their children’s post-secondary education. The Canadian government offers several incentives to encourage parents to save in an RESP, making it one of the most powerful tools for funding education. Let’s explore the features, benefits, and mechanics of the RESP in more detail.
1. How RESP Works
An RESP allows parents (or other contributors) to invest after-tax money for a child’s future education. While contributions are not tax-deductible (unlike RRSPs), the investments within the RESP grow tax-free. When the beneficiary (the child) enrolls in an eligible post-secondary institution, they can withdraw funds to pay for their education. These withdrawals, called Educational Assistance Payments (EAPs), consist of investment income and government grants.
The beauty of an RESP is that EAPs are taxed in the hands of the student, who typically has a lower income and is thus subject to little or no tax.
2. Government Grants
One of the most significant benefits of opening an RESP is the Canada Education Savings Grant (CESG). The government matches 20% of your annual contributions, up to a maximum of $500 per year, with a lifetime limit of $7,200 per child. This means that for every $2,500 you contribute annually, the government adds $500 to your child’s RESP.
In addition, low-income families may also qualify for the Canada Learning Bond (CLB), which provides extra contributions for children born to lower-income families.
3. Tax Benefits
RESPs offer tax-deferred growth. The money you invest in the account can grow through interest, dividends, or capital gains, and none of this growth is taxed as long as it remains in the account. Only when the funds are withdrawn in the form of EAPs is the investment income taxed, but as the withdrawals are made by the student, they often pay little to no tax due to their low-income status during their academic years.
4. Types of RESP Accounts
There are three types of RESP accounts, each offering different advantages depending on your situation:
a) Individual Plan
This type of RESP is intended for one beneficiary, who can be a child or an adult. The contributor doesn’t need to be related to the beneficiary, making it flexible for family friends or other relatives to contribute. If the beneficiary decides not to pursue post-secondary education, the plan can be transferred to another person.
b) Family Plan
A family RESP can have multiple beneficiaries, but they must all be related to the contributor by blood or adoption. The advantage of this plan is that if one child decides not to pursue post-secondary education, the funds can be used by another child in the plan. The lifetime maximum contribution limit for all beneficiaries remains $50,000 per child.
c) Group Plan
Group RESPs are managed by organizations that pool together contributions from multiple families. The earnings are then divided among the beneficiaries who attend post-secondary education. These plans tend to be more restrictive and often come with strict rules on contributions and withdrawals, making them less flexible than individual or family plans.
5. Contribution Limits
The lifetime contribution limit per beneficiary is $50,000. There is no annual contribution limit, meaning you can contribute large sums in some years and none in others. Contributions can be made for up to 31 years, and the plan must be terminated within 35 years of its creation.
It’s important to note that there’s no tax refund for contributions made to an RESP, unlike with RRSPs. However, contributions can be withdrawn at any time without tax implications since they were made with after-tax dollars.
6. What if the Child Doesn’t Attend Post-Secondary School?
If the child does not pursue post-secondary education by age 21, and more than 10 years have passed since the RESP was opened, the contributor can close the RESP account. The original contributions can be withdrawn tax-free, but the investment earnings will be considered Accumulated Income Payments (AIPs) and taxed at your regular income tax rate plus an additional 20% penalty.
However, there are alternatives to withdrawing and paying taxes on the accumulated income:
- Transfer to an RRSP: If you have RRSP room, you can transfer up to $50,000 of the RESP’s growth into your RRSP to avoid the penalty tax.
- Change the Beneficiary: You can name another child or family member as the new beneficiary, provided they are under the age of 31.
f the beneficiary does not attend post-secondary education and you are looking for ways to avoid paying taxes on the accumulated income in an RESP (Accumulated Income Payments or AIPs), there are several strategies to manage these funds without heavy penalties:
Transfer to RRSP:
- One of the most tax-efficient ways to handle unused RESP funds is by transferring the accumulated income (up to $50,000) into your RRSP (Registered Retirement Savings Plan), provided that you have sufficient contribution room. This strategy defers the tax until the money is withdrawn from the RRSP, where it will be taxed at your income rate at the time of withdrawal.
- By doing so, you avoid paying the additional 20% penalty tax that would apply to AIPs if they were simply withdrawn from the RESP account.
Educational Assistance Payments (EAP) for Another Beneficiary:
- If you have a Family RESP, you can transfer the funds to another child within the family who plans to attend post-secondary education. This flexibility ensures that the grants and the accumulated income can still be used for educational purposes. In this case, you avoid the taxes and penalties altogether, as the funds will be used for their intended purpose.
Change of Beneficiary:
- In an Individual RESP, you may change the beneficiary of the account, provided the new beneficiary is under 21 years of age and a family member of the original beneficiary. This allows the RESP to remain tax-sheltered and eventually be used for educational purposes. No penalty applies if this transfer is made correctly.
7. Withdrawals: Educational Assistance Payments (EAPs)
When your child attends a qualifying post-secondary institution, they can withdraw money from the RESP to cover tuition and other expenses. The withdrawals are classified as either:
- Educational Assistance Payments (EAPs): These are taxable and include government grants and investment income.
- Post-Secondary Education Payments (PSEs): These are the contributions you made into the RESP, which are not taxable when withdrawn.
Your child can use the funds for a wide variety of education-related expenses, including tuition, textbooks, housing, and even transportation costs.
8. Maximizing RESP Growth
Since contributions are not tax-deductible, maximizing the growth of the RESP lies in taking full advantage of the government grants and investing the funds for long-term growth. By starting early and investing in diversified assets like stocks and bonds, you can allow the money to grow significantly over the years, potentially leaving your child with a substantial sum by the time they enter university.
For example, a parent who contributes $2,500 annually for 14 years and receives the full CESG grant could amass around $70,000 by the time the child turns 18, assuming an average annual return of 5%. This would cover a significant portion of post-secondary education costs.
An RESP is a powerful and tax-efficient way to save for a child’s education. With the government matching contributions through the CESG and the tax-deferred growth on investments, it offers parents a reliable method to ease the financial burden of higher education. The flexibility in RESP accounts ensures that families can adapt the plan if a child decides not to pursue post-secondary education, giving peace of mind to contributors.