RESP: How Does it Work?

Do you have a child who lives in Canada? Then you probably know what an RESP is. It’s one of those money tools that sounds fantastic but maybe makes sense only after some explanation. What is an RESP meaning in the first place? How does RESP work? And should you have an RESP? We’re going to explain it all in plain, simple language.

What is an RESP?

A RESP, or a Registered Education Savings Plan, is a special type of savings account for saving just for your kid’s education. It’s a registered plan with the government, and that carries some extra benefits. The money you put in an RESP gains interest tax-free, and even gets rewarded a bonus in the form of grants from the government. It’s a long-term plan with a bonus. The intention is to provide your child with greater access to post-secondary education when the occasion arises.

Notice that the RESP is typically kept open for 36 years (or 40 years for qualified beneficiaries of the disability tax credit). Once this is over, unused amounts and unused government grants can either be subject to penalties or clawbacks.

Three general types of RESP accounts exist, including:

1. Individual Plans: Ideal for a single beneficiary. These plans are for you in case you have a single child or you wish to have savings held apart.
2. Family Plans: Permit several beneficiaries as long as they are biologically or adopted related. This is suitable if you have more than one child because monies can be divided among siblings.
3. Group Plans: Provided by some scholarship plan sellers, these plans combine contributions from multiple subscribers. While they are more restrictive in their rules and charge more fees, they may provide lower administrative fees.

How Does an RESP Work?

It is easy to open an RESP. You can open one at a bank, credit union, or financial planner. To begin, you will need your child’s Social Insurance Number (SIN). After the account is opened, you can begin to contribute. There is no law regarding how much you must contribute a year, but there is a 50,000 lifetime contribution per child. That means you cannot contribute more than 50,000 per child regardless of how long the account lasts.

One of the greatest benefits of an RESP is the government grants. The primary grant is the Canada Education Savings Grant (CESG). In this, the government will match 20% of what you contribute on the first $2,500 that you contribute annually and you can qualify for up to $500 annually. During the lifetime of the RESP, the grant can reach a maximum of $7,200 per child. If you don’t contribute enough in one year to qualify for the full grant, you can contribute catch-up amounts in subsequent years. 

There’s also the Canada Learning Bond (CLB) for poor families. This grant does not call for any contribution on your part. It’s bona fide free money to start you off in savings. The CLB provides a single $500 at birth, and an extra $100 for every year that qualifies after that. Unlike the CESG, you do not have to deposit anything into the CLB. It is straight government assistance, providing your child with an edge in their educational future. 

Your RESP can have money invested in a range of vehicles, including stocks, bonds, or mutual funds. This enables your money to grow over time, likely faster than if money simply sat in a regular savings account. But don’t forget, investments are not risk-free. Your investments may go up or down in value, so it is always prudent to seek the advice of a financial advisor to choose the best for your family. 

When your child is old enough to pursue post-secondary education, you can withdraw the money. The savings, grants from the government, and investment returns may be used to cover tuition fees, textbooks, and living costs. There are certain restrictions regarding when and how you can withdraw the money, which we will discuss later.

Benefits of an RESP

RESPs have a few primary advantages which, in their own right, render them a very interesting opportunity to invest in for Canadian households interested in prepping for the future. Amongst these include:

1. Accelerated Savings Through Government Contributions

Perhaps the greatest advantage of an RESP is the government contribution. The CESG, usually a 20% match of what you put in, causes your account to actually increase an additional twenty cents for nothing with no additional effort on your part. For families that have eligible children, the CLB adds even more value to the RESP by paying you money even when you can’t afford to contribute much yourself.

2. Tax-Free Accumulation

The feature of tax-free accumulation of investment returns is a massive benefit of an RESP. In the long run, the tax-deferred accumulation can lead to a much greater fund for education than you could otherwise build in a taxable account. The compounding effect on returns is enhanced when you’re not giving up some of your earnings to taxes year after year.

3. Investment Flexibility

RESPs permit you to select where your contributions will be invested. You have options in investment products like mutual funds, stocks, bonds, or Guaranteed Investment Certificates (GICs). This enables you to personalize the investment plan based on your risk tolerance and investment objectives, whether you prefer conservative growth or an aggressive investment.

4. Reduced Tax Burden for Students

During withdrawal, the tax is usually charged on the government grants and income and not on the contributions. Students receive very little or no income while studying, and as such, they would be placed in the lowest tax bracket. This ensures that the withdrawn amounts have the least amount of tax withheld. RESP withdrawals are a cheap method to cover tuition fees, books, and other associated costs of learning.

5. Encourages Early Financial Planning

To save an RESP early is to have the potential to save a lot of money for your child’s education. The earlier the money has time to compound, the more you benefit from tax-free compounding and other government incentives. Saving early not only gives you the largest monetary return, but it also teaches your family the value of saving and planning ahead.

RESP Withdrawal Rules

When the time comes to use the money in your RESP, there are certain important rules to know. Your own contributions and the government grants and investment earnings (EAPs) are split into two components in the account.

Your money can be taken out tax-free whenever you wish without limit. This is because you’ve already paid tax on the money that you put into the account. The negative is that the EAPs are taxed when taken out. The positive is that your child, who would probably be in a lower tax bracket than you, will probably pay the taxes.

There are certain restrictions on how much you can withdraw in EAPs during the first 13 weeks of school. It’s a maximum of $8,000, but after that, there is no restriction. Your child will need to provide evidence of enrollment in an approved educational program for withdrawals. This may be a university, college, vocational school, or even certain apprenticeship programs.

Common Mistakes to Avoid

Although RESP savings are a wonderful benefit, several risks are present to minimize their effectiveness if not properly controlled:

• Under-Contributing

Far too frequently, an error is not contributing sufficiently to earn the maximum CESG. Remember that to be eligible for the maximum $500 annual grant, you need to contribute at least $2,500 per year. Failing to reach this amount leaves money on the table.

• Missing Contribution Deadlines

Government grants are subject to deadlines and have deadline requirements. The CESG, for example, is only available until the end of the year your child is 17 years old. Failing to contribute in a timely manner will erode the total amount of grant money you’ll receive.

• Selecting the Wrong RESP Type

Not all RESPs are the same. Selecting an individual, family, or group plan will depend on your own circumstances. For example:

• An individual plan is best if you only have a single child.
• A family plan may be more appropriate for more than one child.
• Group plans, although at times having lower fees, may be more limiting with respect to investment options and withdrawal provisions.

Invest the time in doing research and choose the proper plan to achieve maximum benefits.

• Forgetting to Monitor Investments

Once you’ve opened an RESP, it’s important to periodically review your investments. Market conditions change over time, and an investment strategy that worked initially may need adjustments. Regular monitoring helps ensure that your RESP stays on track to meet your long-term goals.

• Early Withdrawals for Non-Educational Purposes

RESPs are designed to pay for education. Expenditure on ineligible education expenses can lead to fines and repayment of government grants. Close scrutiny of withdrawal policies is required to prevent expensive errors.

Conclusion

An RESP is one of the most effective methods of saving for your child’s education in Canada. It provides tax-free growth, government incentives, and flexibility, and is a potent long-term saving tool. By beginning early, investing regularly, and steering clear of common pitfalls, you can establish a solid financial foundation for your child’s future.

One of the greatest gifts you can provide your child is education, and an RESP makes it easier to afford. If your child has his or her heart set on attending university, college, or trade school, an RESP can help make it a reality. So start today, open an RESP and begin saving for your child’s future.