Do the new government grants of up to $7,200 automatically make RESPs the best way to save for a child's education?

 "Not always," says Talbot Stevens, financial educator, speaker and author of Financial Freedom Without Sacrifice. 

Combine the grants of up to $400 a year with the fact that RESP growth compounds tax-deferred like an RRSP, you get your contributions back tax-free, and the growth is taxable in the child's hands where it will often face little, if any, tax, and it's very easy to think that RESPs are the best way to save for post-secondary education. 

"These benefits must be evaluated in terms of the goal that we're trying to achieve," explains Stevens. "For income-based goals, like saving for retirement or an education, after-tax income is all that matters. Unfortunately, most analysis compares before-tax values at some time in the future."

Focusing on after-tax income is especially relevant because the "In Trust For" (ITF) approach of investing for capital gains in the child's name can result in almost all of the withdrawals coming out tax-free. With an RESP, the contributions are recovered tax-free, while all of the growth is taxable as income in the child's name. 

Consider the scenario where the parents take maximum advantage of the new RESP grants. Starting when the child is born, they invest $2,000 a year for the next 18 years to get the maximum $400 grant added to their RESP each year for a total grant of $7,200. 

Assuming they invest well into equity funds averaging 10% returns, the RESP will be worth just over $120,000 when the child is ready to start post-secondary education. Investing $2,000 a year using an "In Trust For" approach would be worth $100,000 eighteen years later. The $20,000 difference is due to the growth of the grants over time.

Based on modest increases in the cost of tuition, a student should be able to earn about $19,000 tax-free 18 years from now. If the student earns a high income of $17,000, the additional after-tax income that can be produced from the $120,000 of RESPs is $26,770 a year for four years.

However, the $100,000 in the "In Trust For" approach, can produce $28,640 after-tax for four years — a 7% increase of almost $7,500 over four years. This is possible by triggering all of the capital gains in the child's name at 0% tax before they start school. Without triggering the gains, the "In Trust For" approach produces a 4-year after-tax income of $26,480, or 1% less than RESPs with the new grants. The 4-year after-tax income (ATI) results from other strategies are summarized in the table.

"In this scenario, not properly analyzing the after-tax income merits of all possible strategies would have cost the family over $7,500 — after-tax," adds Stevens.

 General conclusions from the analysis include:

•   For most students with average or modest incomes, RESPs will generally produce more after-tax income than even the best managed ITF approach.
•   The downside of paying an extra 20% penalty tax on the RESP growth if the child doesn't go on to school can be totally eliminated by ensuring you have enough RRSP room to transfer all of the growth, not including your contributions.
•   Money from an ITF approach can be used by the child for any purpose, not just an education.  Thus, the ITF is still worth considering for the flexibility or if you want to use all of your RRSP room, especially if the student is going to earn a high income.
•   Amounts contributed to an RESP beyond $2,000 every year will not be eligible for a grant.  Contributing more than this decreases the relative benefits of RESPs.
•   With the $400 grant added in, contributing only $2,000 a year to an RESP for 10 years or more should cover a significant portion of the future education.
•   After-Tax Income results are very specific to an individual's situation.

Stevens emphasizes that the need to properly evaluate the after-tax income merits of retirement strategies is even more important because much larger dollars are involved and because RRSPs are fully taxable, while all non-registered approaches are only taxed on the growth.

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Talbot Stevens is a financial educator, industry consultant, and author of "Financial Freedom Without Sacrifice" and "Dispelling the Myths of Borrowing to Invest". For other story ideas, visit the Free Resources menu of www.TalbotStevens.com. For more information, contact Judy Culford, Communications Director for Talbot Stevens, by calling (519) 663-2252, or emailing judy@TalbotStevens.com.