By Christopher J. L. Warner FCSI CFP CIM PFP
How to Effectively Save for Post-Secondary Education
If you’ve read part 1 and 2, then you already know how likely it is that education costs are going to keep growing above inflation. You also have seen how to estimate actual costs for future students to know how much is necessary to save.
Let’s assume that we now have an education savings goal in mind. What then is the best means to save to reach it?
It should be made clear that there is no “one size fits all” solution, but there is a general order of savings vehicles that will work for most people. Those are:
- Registered Education Savings Plan (RESP)
- Tax-Free Savings Account (TFSA)
- Regular (Non-registered) Investment Plans (IP)
Unsurprisingly, the RESP is the first place to look for education funding. This makes sense since it was designed by the government to fund education costs.
An RESP is a tax-sheltered investment savings vehicle that can be set up for a child by a parent or grandparent (the “subscriber”). The RESP has a lifetime contribution limit of $50,000 per child. A family RESP can also be created for multiple children – the investments are pooled together but the same $50,000 per child limit remains.
Each year until the calendar year of a child’s 17th birthday, a contribution of up to $2,500 can be made into the RESP for each child, which will then receive a 20% matching grant payment (the Canada Education Savings Grant or “CESG”). The CESG has a lifetime limit of $7,200 which, once reached, means future contributions will not generate CESG payments.
If the RESP isn’t started right when the child is born, missed years of RESP contributions can still be caught up, though the catching up process may not be able to occur immediately. CESG will only pay a maximum yearly payment of $1,000. Since the CESG is a 20% matching payment, this means that a maximum of $5,000 yearly catch-up contributions can be made. Anything over $5,000 will not qualify for CESG and the overage will not carry forward to the next year.
Outside of the CESG, there are often other RESP bonds/grants available depending on province and the income level of the subscriber. These vary widely and are not guaranteed for every child, so will not be referenced further in this article – interested families should investigate this locally, we suggest checking your local provincial or territorial government website and searching “post-secondary savings and students.
When it comes time for the child to enroll in post-secondary education, the RESP subscriber submits proof of enrollment to the RESP provider and requests withdrawals be made from the account. The amount of the withdrawals are entirely decided by the subscriber, with some minor limits for the first 13 weeks of schooling. After 13 weeks, there are no withdrawal limits.
The withdrawals can be non-taxable and/or taxable in the hands of the child depending on where from within the RESP they occur from:
- Withdrawals made from the sum total of the RESP contributions are considered non-taxable.
- Withdrawals that are made from any investment growth or government grants are considered taxable in the hands of the child.
Even with taxable withdrawals, the RESP is still usually a significant advantage over the subscriber’s personal savings. A student is much less likely to have a high marginal tax rate if any taxable income at all. In 2022 the first $14,398 of income is non-taxable. Any income above that would be taxed at a relatively low rate – certainly lower than most working adults or retirees are paying. And, recall that all the investment growth in an RESP is tax-sheltered until withdrawal, unlike personal savings.
Examples of RESP Funding
How does RESP funding look in practice? Let’s examine to make these terms and rules clearer.
Most parents start a RESP by making the minimum annual contributions to maximize the CESG. Following this strategy would generate the following growth:
Maximizing the $7,200 CESG at 20% per year requires a cumulative contribution of $36,000. Assuming 5% growth, the RESP will grow to $84,283 by the time the child is ready for post-secondary.
This is great, but if we are concerned about education costs exceeding $100,000, what else can be done? As mentioned, the RESP limit is $50,000 so a subscriber with the means could keep contributing beyond the CESG maximum:
After the grant is maximized, adding the $14,000 extra top-up will boost education savings to $103,039. Now we finally reach the six figure debt coverage that was the starting point of this article. For those with further savings aspirations, there is a way to go even beyond this.
Assuming a subscriber has savings available when opening the RESP, they could instead contribute the entire $50,000 up front. This would forgo all of the CESG but could allow for more time for the tax-sheltered investment to grow. Perhaps counter-intuitively, giving up on “free” grant money can produce a superior result:
Now we reach $133,864 in education funding – about 30% more than from maximizing the CESG. This is roughly the limit of RESP growth simply from contributions. Of course, a higher rate of return can increase savings further but one should be judicious in projecting rate of return. For RESPs, it is recommended to only assume a growth rate that has an extremely high probability of being achieved. This ensures that the child will not end up with less education funding than expected when it comes time to enroll.
For those seeking excess savings from what the RESP can provide, the TFSA is the next logical step. The TFSA is a personal tax-sheltered investment savings vehicle. For anyone who was 18 or older in 2009, the maximum contribution limit is $81,500 and increasing by $6,000 annually. If one is not using all of the TFSA contribution room for their own savings goals, then it can be an ideal place to invest after-tax income towards a child’s education.
Note that a TFSA cannot be opened on behalf of another individual. If a parent/grandparent plans to save for a child’s education using a TFSA, it will be by using their own TFSA. Also, there is no formal way to designate the TFSA funds as “set aside” for the child. This is up to the investor to withdraw and gift the funds to the child in the future. The investor may begin saving, intending the funds to be for a child’s education but then may change their mind later and use the funds for themselves – there is nothing stopping them from doing so. This type of flexibility can be a benefit to the investor but will also add extra layers of complexity for family dynamics, fund management, and estate planning.
A TFSA does have advantages over the RESP if one is planning to contribute $50,000 or more for the benefit of the child’s education right away. One, each TFSA can accommodate up to $81,500 of savings, which would mean $163,000 in the case of two parents each using their TFSAs. Two, the future withdrawals coming out of a TFSA will have no tax implications, whereas the RESP could have minor tax paid on a portion of education withdrawals.
The RESP remains advantaged over the TFSA in other ways. One, the RESP is specifically structured for the benefit of the child’s education which makes ease of management and clarity easier. Two, for families with several children to save for, the RESP limit of $50,000 applies per child, whereas the TFSA is limited to what the adult saver has available – a 4-child family all but necessitates a group RESP. Three, the TFSA is commonly used as a savings vehicle for other goals such as retirement, short term expenses, and future gifts (i.e. helping family with house down payments). This will often use up all of the contribution room itself, leaving no room for children’s education savings. For those reasons, the TFSA is likely the second choice for most families in education savings.
A regular Investment Plan (“IP”) would be the third main choice for education savings. There is no limit to what can be saved in one, though there are no grants or tax-sheltering benefits either. This is simply an investment account set up by the investor who will plan to gift after-tax proceeds to the child in the future, at their discretion.
With an IP, after-tax savings can be invested in a substantial variety of investment vehicles. As those investments earn taxable income, the tax owing on realized income is paid at the investor’s marginal tax rate on an annual basis. This is different from RESPs and TFSAs, where all growth is sheltered. For the IP, the ability to defer tax will allow for more growth through compounding, therefore tax-efficiency becomes a key consideration for the investments. Put simply, if we don’t pay tax until we have to, we keep the investment whole and able to earn an investment return against the entire investment instead of the only on the investment amount minus yearly tax costs.
Interest income from bonds, GICs, or savings accounts will be fully taxed which makes it the least efficient form of income. Dividend income on the other hand will receive a partial credit which follows a gross-up formula. Capital gains income is the most tax efficient form of income – it receives a 50% tax exclusion.
Using the more tax efficient forms of income, capital gains and dividends, usually means equity investments (a.k.a. stocks). This also usually means a higher degree of investment volatility and risk. Luckily, time is a helpful factor in mitigating equity risk – the longer the investment time horizon the lower the historical probability is that there will be a negative return on investment. If a parent/grandparent is saving for post-secondary costs for a newly born child, that means the time horizon for the investment is at least 19 years. This is considered a long time horizon and means that equity investments are more appropriate to consider.
Other education savings vehicles and strategies exist but mostly do not represent enough potential benefits to warrant explaining. The conventional methods listed above will likely solve the funding goals of 99.5% of Canadian families without adding complexity, tax concerns, and/or legal risk.
It should also be said that Canada has plenty of access for students to borrow their own funds towards their education. These include federal student loans, provincial student loans, and private financial institution student loans.
Unlike savings or gifted funds, borrowing will place some or all of the funding onus on the student. The student then needs to plan to repay the loans after completing their education. This can delay future goals such as a first home purchase or starting a family. Still, the hope would be that the cost of the loans is outstripped by the increased future income that comes with additional education.
There is also an argument that student loans teach personal fiscal responsibility – this veers into the territory of personal values and so is best left to each family to decide on.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required securities commissions.