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.
Hi Guys,
A couple of thoughts here. One is a link to tuition fees check out link from CBC
http://www.cbc.ca/news/interactives/map-tuition-fees/
When you think about RESPs help but fall short and over time the RESPs is gone. RRSPs…has some good things, but the government has and will change rules here and the tax bill will be paid in the future at future tax rates?! My guess is taxes are not going to be much less in the future…like gas prices.
In a nutshell fees are going up higher than inflation and what people can make in the market.
The other big thought is nobody is using a Financial Model. For example, if one has limited amount of money where to put it? How does this impact my life 20, 30 years from now?
If you want, I can scan a model I use. This model includes real estate, RRSPs, wills, insurance, (home, auto, life, disabiltiy, etc.).
A financial model should show inflation, taxes, how a disability or premature death changes everything. Since everyone is different, no two models will be the same.
Cheers,
Brian
Brian, I love the experience and obvious wealth of knowledge you bring to the comment board, but your confusing this situation in order to pump your own financial model is not cool.
I’m not even sure what you’re trying say here. RESPs are gone? What does that mean? You will have to pay taxes on RRSP withdrawals? Yes, you will… How does this affect the comparison? Fees ARE NOT going up higher than what people can make in the market, especially when you consider that with the RESP program you get an automatic 20% ROI from the CESG. You also need to factor in that governments allow more money in these accounts, and wages are also rising with inflation (albeit not at the same rate for the last 25 or so years).
This article is not a personalized financial model, it is a comparison between two savings vehicles for your money, and it is that simple my man.
Hi Teacher Man,
Sorry if you took offence to a financial model.and my offer to add something here. One idea is to see what kind of financial models are out there and have that for a future story.
One needs to look at the long term pros and cons of RESPs and RRSPs etc.
RESPs and RRSPs have advantages and disadvantages. I don’t know if you reviewed the link I added regarding tuition fees let me know.
I understand you are trying to make it simple for your readers but my point is what is the out come 20 to 30 years out? Why not look at that? One may get a different answer.
Also, RESPs and RRSPs even TFSAs is not the only tools for people.
Cheers,
Brian
Hey Brian,
I just don’t want to make things appear more complicated than they truly are for our readers. You have to be careful when stating things like RESPs are not good because of inflation. This is improper logic to provide to our readers. I think this article does a pretty good job of looking at the pros and cons of RESPs and RRSPs. I do mention that RRSPs are dealing with a different investing time horizon and subsequently different conditions apply. I think any financial model can be set up in order to slant results in a certain way. I would much rather people get a fundamental understanding of how certain savings vehicles work and then make their own conclusions as opposed to blindly placing face in a “financial model” that makes several assumptions that may or may not be relevant.
I did take in the link. I’m pretty familiar with rising tuition costs, and I did review the link. I don’t understand how the rising costs of tuition effects the choice of what savings vehicle to use? The costs are going to rise regardless of where you put your money, so it is irrelevant to the conversation.
RESPs, RRSPs, and TFSAs are not the only tools, that is correct. That being said, they are by far the most accessible, and in the vast majority of cases they are the best option at what the purport to do for the majority of Canadians. I think it very worthwhile to compare two of the most popular investment vehicles in a head-to-head comparison in order you help you Canadians.
Thanks again for being such an active participant on Y&T, we really do appreciate it!
Hi Teacher Man,
Lets start again.
Fees are going up faster than inflation. (tuition/rent/food/gas/etc.)
The 7% is not likely to happen as an average for the 18 years. (return).
RESPs are great but your case studies starting at 5 and putting $2500 per year and using reasonable increases of 5% plus per year the child is still short.
Since many readers may not understand insurance and how it works, it can be accessible and more flexible.
If a parent is disabled contributions will not be made to the plan.
Insurance does this.
If money is withdrawn from an insurance policy (the right kind) and paid back the cash value is credited as if no money was ever withdrawn.
Values on the right kind of insurance policies can never go down.
No limit on the cash value insurance policies (or at least very high).
RESPs are great because of the 20% added by the government but have limits on how you can get your money.
In the end having a mix of say RESPs and insurance maybe better, but as I said before one needs a model to see if it makes sense.
Ok Brian, at least we are discussing specifics now, I’ll reply in kind:
1) Fees are going up faster than inflation. This is irrelevant as to the best way to save money.
2) What assumptions do you make to say that 7% is not a probable rate of return? The S&P 500 has returned over 10% since its inception. There is still plenty of growth potential in the world’s markets.
3) If a parent is disabled, the vast majority of them will get an insurance settlement, depending on their employment. This can then be invested on the child’s behalf, or in an RRSP however they see fit.
4) So your withdrawing money from an insurance plan, only to put it back in again at a later date? This is really what you are suggesting as a viable alternative to an RRSP or an RESP? That sounds like an insurance salesman to me, oh, and by coincidence your website is one that sells insurance.
5) I’ve seen and heard this pitch before. The money inside of insurance funds grows at a much slower rate than if you invest it on your own behalf. This is why most financial gurus (including David Chilton most notably) will advise their clients to use term insurance “and invest the rest.” Using insurance for what its meant to be used for – protection against events that are out of your control, makes much more sense than trying to use it as an investment strategy. Basic logic tells you that insurance companies take your money (the premiums you pay) and invest it, and then pay settlements out of the pot. Their profit comes out of your earnings. It has to, or insurance companies would have to run on volunteer labour!
6) You comment that withdrawing from an RESP has strings attached? It’s pretty straightforward, and there is a great feature that allows you roll the money into your RRSP if none of your children use the money (although they almost assuredly will in this increasingly information-based economy). Your proposing that taking money in and out of an insurance plan doesn’t have strings attached? Come on man…
7) I want one specific situation where any amount of money in an insurance plan would be better from an investment standpoint than in an RESP. The fact is that it does not exist. Please come bearing hard facts and quit trying to merely sell insurance, or I will forced to disallow comments from here on out Brian.
Teacher Man,
I will address two points
# 2 The “10% ” returns rates vary for different times one if you look at Jan 1 1999 to Dec 31 2011 the S& P returns were 3.85% as one example. check out http://www.moneychimp.com/features/market_cagr.htm
#7 If use an example of a 20 pay insurance policy for a five year old male at $2500/year the cash value is $67,880 at age 25 and death benefit of $435,948
At age 55 the death benefit is $1,331,919 and the cash value is $592,031 This keeps going in value over one’s life time.
The insurance idea is not to say RESP are bad (the 20% is great) but later in life the money is spent. The “strings” is in order to keep the policy alive one can borrow up to 90% of the cash value. Also one would want to repay the amount borrowed over time. Lets face in a $1,000,000 plus policy will cost a lot at age 55.
I can comment on the other points but I will see if you are open minded here on other ideas. I sent an e-mail to you on a book you may want to read, let me know if you got it.
Brian
Brian,
2) Of course an “average” of 10% varies Brian… We could both cherry pick times when the market did well or didn’t do well, but the bottom line is that the long-term average is over 10%.
7) The death benefit of insurance is irrelevant to its use as a savings vehicle. Besides, why do I want a million dollar insurance policy when I’m 55? About the only time I ever want that much insurance is if I have just moved into a large house and have three young children. To use your own numbers, if a 20-year old took those insurance premiums and put them in a TFSA (the RRSP comparison isn’t even valid because it is pre-tax dollars which is another huge advantage), invested in the market average (I’ll use returns of 9% just to be conservative) he would have $638,846.73 by age 55. That money could now be taken out whenever they wanted, as opposed to borrowing and returning and the tax ramifications of that!
I like to think I’m pretty open minded, but your facts just aren’t going to line up in the case Brian. It’s impossible given the basic business model of an insurance company. The insurance companies invest in the same markets I do, then they take their cut before anything else; consequently, we’re all better off skipping the middleman.
Term insurance for whatever you need, and invest the rest!
Excellent article Teacher Man. It is worded well and gives great examples that make the understanding very simple. I also completely agree with your points in the discussion between you and Brian.
The best thing I learned from my father is to take advice from those who have attained the goals you wish to achieve. Many have preached to me about these insurance models and many other wonderful schemes, none of them seem to be at the same point in life as me though… funny how that works. (unless they are the middleman or are working for the middleman himself).
Thanks Randy!