For many young and middle-of-the-road families out there the RRSP vs RESP account debate is a very real one that usually creeps up right around tax time every year if not more often. It is often a confusing topic for some people because the financial industry spends a lot of money trying to convince parents that they need to max out RRSP and RESP accounts, and it is often extremely difficult to do both as people seek to balance mortgages, student debt, and life (that pesky life, always seems to get in the way of the raw numbers right?). There are obviously numerous aspects of each person’s financial situation that will come into play when looking at whether a RRSP or an RESP contribution is right for them.
A Hand Up Either Way
The first thing that parents need to compare when looking at the RRSP vs RESP account debate is that the government wants you to use both of these plans, and they are willing to help you out with each one. The difference lies in just how they help you out. Both plans are registered savings plans, and any income generated within those plans from interest, dividend income, or capital gains is tax deductible. Keeping those investment gains compounding away from the long arm of the tax man is absolutely essential to growing your money. Where RRSPs and RESPs differ is in how the government contribute to the plan. RRSP contributions are tax deductible. This basically means that the government will pay you back at your marginal tax rate (the highest rate you pay) on whatever money you put into your account, BUT the flip side of that is that it will also be taxable in your hands as a retiree when you take out. Although the majority of people have a lower income level when they retire, most Canadians that I know will still pay a combined federal/provincial marginal tax rate of at least 24-25%.
Tax Deduction vs CESG
RESP contributions, in contrast, are not tax deductible. The government does add a cool incentive to put money away for your child’s education in the form of the Canada Education Savings Grant or CESG. The CESG is an agreement by the government to chip in 20% of your contribution into the RESP account up to maximum of $500 every year. This means that if a parents puts in $2500 into their account, the government will contribute $500 into the RESP, bringing the total investment to $3000. The government’s money will now work for you and can be used to create investment gains just like your own money. In terms of taxation, money that is taken out of an RESP is taxed in the hands of the student receiving it. Most students do not earn enough income to pay taxes once their basic exemptions and tax deductions/tax credits are added in, so very little of the RESP money usually finds its way back into the government’s hands (well, unless students use it to pay for alcohol, which has incredibly high sin taxes attached… it’s not like anyone would do that though right?).
RRSP vs RESP Account Case Study
So before we look at some of the specifics of each plan, let’s examine a couple of case studies:
Mike and Mindy
Mike and Mindy are 40 years old and have a five year old child. They want to help out their little darling and they believe they should open a RESP. At the same time, they know that life is short, and they hope to retire, or at least severely cut down on their full-time work load at 55. Mike and Mindy are both professionals and each make 70-80K a year.
For the sake of our comparison, we’ll use fairly safe investment returns of 7% for both of the accounts. Admittedly this is slightly unfair to the RRSP, as one could argue you could take on a little more risk inside of an RRSP considering the investment time horizon is a little less rigid.
Mike and Mindy could contribute $2500 to an RRSP. Their marginal tax rate is 39.4% (taking Manitoba’s provincial rate), so they receive a nice little tax refund of $984. For the sake of argument, we’ll say that Mike and Mindy are dependable little savers and that they turn around and save the tax refund in a registered plan as well. This gives them a total investment of $3,484. In 15 years of 7% returns, their investment has compounded to a nice chunk of change at $9,612.47.
They could also contribute $2500 to an RESP. The government would kick in $500 as part of the CESG to bring their overall investment to $3,000. After 15 years, when little Suzy is on her way to a medical degree, they have $8,277.09 in the account.
At this point, it looks like the initial advantage of that tax deduction beat the CESG contribution, all other things being equal for this high-income family, but we have neglected to measure the tax impact upon withdrawal. Little Suzy will be allowed to have about 22K or so (or whatever the inflation equivalent is by then) before she has to pay any taxes, so we’ll call her RESP money tax-free. Mike and Mindy knew they wanted a fair degree of security in their retirement, so they have a decent income and a marginal tax rate of 27.75%. This means that their after-tax return on their original investment will be $6,945.01. While this is still pretty nice, it does illustrate how important tax considerations are in financial planning.
John and Jane
Just because I want to keep things simple, let’s say that John and Jane are very similar to Mike and Mindy. They have the same income levels, expect the same returns, both want to retire at 55, and have a 5-year old. The difference is that John and Jane are 30. Let’s check out what the increased compounding time (now 25 years) does for our RRSP numbers:
$3,484 ($2,500 contribution, plus reinvestment of tax refund) over 25 years of 7% returns is $18,909.18. After factoring in our 27.75% tax claw back when we withdraw the money, our investment has still generated $13,661.89. This illustrates just how powerful that extra compounding time is. This is also probably being too conservative, because with a 25 year investment window, more risk could easily be taken, and a higher corresponding return would be very normal to assume.
Variables in RRSP vs RESP
Now there are obviously a ton of variables that these case studies don’t take into consideration. A family with a more average income would get less of a tax deduction, and it’s possible that our cast studies would have less of an income in retirement as well. The CESG contributions from the government represent an automatic 20% Return on Income (ROI) and it appears because of this RESP contributions gain a short-term advantage. In the RRSP vs RESP account debate however, investment time horizons pay a key role, and the RRSP has a considerable edge there. One other little side note is that any tax credits that a child does not use while they are going to school can be kicked up to the parents if they so choose. The RESP money might negate some of these credits, but that is a lot of variables to plan for.
…and The Winner Is:
If you are even talking about the RRSP vs RESP account decision then you are further ahead than most. The RESP plan is a great boost to your child’s finances, and if it prevents them from going into debt, the savings become even greater because of the interest charges that were prevented on the hypothetical debt. On the other hand, the earlier you put money into your RRSP account (and reinvest the tax refund, instead of spending it like so many people do) the more security it will give you later in life. If a child does not use their RESP, it can be transferred into a sibling’s RESP account, or rolled into an RRSP account with the loss of the CESG and the investment returns the CESG has produced. In a perfect world, you should definitely consider paying into both plans, but the closer your child gets to post-secondary age, the more attractive that automatic 20% ROI looks when you invest through an RESP account.