STRATEGY SHEET
February 2002
A Tax-Deductible
RESP Alternative
© Talbot Stevens
One of the most common financial planning goals is to help a child with the ever-increasing cost of post-secondary education.
Registered Education Savings Plans, or RESPs, make saving for an education easier by providing government grants and tax benefits. Similar to RRSPs, funds inside an RESP grow tax-deferred until withdrawn. If the child enrolls in a qualifying school, the growth is taxed in the student's hands, often resulting in little or no income tax. Unlike an RRSP, the amount invested in an RESP is withdrawn tax-free, even if the child does not go on to school.
Although RESP contributions are not tax deductible, the federal government does something even better by providing a free gift called the Canada Education Savings Grant (CESG), equal to 20% of the amount contributed to a maximum of $400 per beneficiary per year.
If the student's income is low enough, they will pay no tax on the RESP income. In these situations, RESPs are the simplest and most effective strategy to save for an education.
RESPs offer many benefits, but not the most critical one for over-taxed Canadians. Although RESPs do not provide investors with a tax deduction, there are at least two alternatives that do.
One approach is to use conservative leverage as a potentially more powerful and flexible way to save for an education.
You get the most RESP benefits by investing $2,000/yr to get the maximum annual grant of $400. This $2,400 grows to $34,800 after 10 years, assuming 8% tax-sheltered returns.
Alternatively, someone in the 40% tax bracket could use the same $2,000 of cashflow to borrow $37,000 at 9% interest. Even with only 8% taxable returns, leveraging produces a slightly higher $36,300 after repaying the loan.
Some of the benefits of leveraging as a tax-deductible alternative to RESPs include the fact that there are no restrictions on the use of the money. If the child does not go to school, there are no penalties as there are with RESPs. In the parents' or grandparents' name, this money can be used for anything, and does not have to be given to the child at all!
The ability for leverage to magnify returns can more than make up for the tax-deferred growth and 20% grants of RESPs, even with reasonable returns and a higher-than-expected cost of borrowing.
Of course, borrowing to invest can help or hurt investors, depending on how it is used. It helps that using $2,000 of cashflow or less results in leveraging only a modest, conservative amount.
Part of my guidelines for conservative leverage is to only borrow small amounts, long term, with the guidance of a trusted advisor. If school is less than 10 years away, use RESPs instead.