One of the least understood registered savings accounts is the registered education savings plan, or the RESP for short. Perhaps you are expecting your first child, or already have one or more children, and haven’t really considered the benefits of an RESP yet. Hopefully after this post, you will have a better understanding of how you can use an RESP and whether it’s worth it for you to utilize.
Firstly, I just want to clarify what an RESP is. An RESP is a savings account that is allowed to grow tax-free and can be used to fund a university/college education for the stated beneficiaries of the plan. It’s important to note that when the money is contributed to an RESP, you do not receive an immediate tax deduction (as with an RRSP contribution). When the money is eventually withdrawn for the beneficiary’s education costs, tax is paid on the earnings generated in the RESP; however, the beneficiary usually pays the taxes. This is advantageous because students are usually very low income earners, and end up paying minimal (if any) taxes on the RESP funds used for education.
Why else would you want to open an RESP? The most important reason by far is that the government actually contributes money to the RESP annually, through 2 programs:
1)Canada Education Savings Grant – Essentially, the government will match a portion of your savings, depending on your family net income and annual savings. Here is the exact amounts:
a)If your family net income is under $37,885 – the government will contribute 40% of your contributions to the RESP for the first $500 you contribute and 20% for next $2,000 you contribute, up to a maximum of $600 per year.
b)If your family net income is between $37,885 and $75,769 – the government will contribute 30% of your contributions for the first $500 you contribute, and 20% for the next $2,000 you save, up to a maximum of $550 per year.
c)If your family net income is over $75,769 – the government will contribute 20% for all contributions up to $2,500, for a maximum government contribution of $500 per year.
The maximum money that can be earned in an RESP from the Canada Education Savings Grant is $7,200. But obviously, those government contributions can earn interest – and there’s no maximum on that. And as well, don’t forget that the above noted numbers are per child.
2)Canada Learning Bond – This program is targeted for lower income families. To qualify for it, your child must have been born after December 31, 2003, and you receive what’s called the National Child Benefit Supplement (monthly payments from the government to help lower-income parents with raising children). The CLB works differently than the CESG – here’s a summary:
a)The CLB will pay $25 to help cover the cost of opening an account
b)The CLB will make a start-up payment of $500 to the RESP
c)The CLB will contribute $100/year until your child is 15 (as long as you still receive the National Child Benefit Supplement
The CLB can contribute up to a maximum of $2,000 for your child’s education. One important note about the CLB – you don’t have to be contributing any annual amount to receive the above-noted government contributions – just by simply opening an account, you can receive CLB benefits.
So is it worth it for you to open an RESP? The question is, when else do you receive free money from the government? And remember, the earlier you collect the government’s funds, the more time it has to earn interest and grow.
What happens if you need to withdraw RESP funds early? You will have to pay normal tax rates (the withdrawals are considered as income) plus an additional 20% penalty (yikes!). As well, you must return any government grants earned over the years of the plan (including the above-mentioned CLB and CESG), although not the interest earned on any grant. However it’s important to note that you only pay taxes on the interest earnings – the principle contributions you made throughout the life of the plans are after-tax dollars (they were already taxed before being contributed anyways). Therefore, the tax hit is not as bad as it seems. There are other ways to mitigate the strict penalties, including transferring the RESP contributions to an RRSP, donate the RESP balance, transfer the balance to another RESP, etc. Talk to your financial advisor.
What constitutes an educational program that an RESP can fund? Well – the list might be a little longer than you think. Besides the obvious Canadian post-secondary institutions, many part-time and even foreign institutions qualify.
The last issue that needs to be dealt with regards the actual plan itself. Should it be self-directed (i.e. you choose the investments) or should it done via mutual funds? Well, it is completely up to you. What I definitely would advise is to invest the majority of it in equities (risky assets), since the time frame is pretty long until you need the funds, and therefore, it’s ok to go for the higher returns. Many banks and different scholarship funds (like “Heritage”) offer RESP plans that may be a better fit for many investors. Why? Because often, RESPs are funded in small amounts over many years. If you self-direct your RESP, than the transaction costs for purchasing equities every time you contribute a little more money can be over-bearing. Scholarship funds will automatically add your money to the fund so you don’t have to incur the transaction costs constantly. When choosing a particular fund, make sure to ask questions like, “Is there an annual service fee?” “Is there a penalty for withdrawing funds?”
For a complete list of relevant questions, and for more information on RESPs, visit http://www.hrsdc.gc.ca/eng/learning/education_savings/public/resp.shtml
I hope you now have a better understanding of RESPs, and I definitely would recommend putting aside some money into an RESP, and watching it grow, along with receiving government payments. This is especially true in a case where parents are young, since a) you often qualify for higher government contributions and b) there’s more time for your RESPs to grow, so that the cost of your child(ren)’s education may become less of a burden in the long run.
Wednesday, June 23, 2010
Tuesday, June 8, 2010
RRSPs or TFSAs?
So you’ve set aside some money to save for a registered savings account. Question is, what should you use, an RRSP or TFSA? What’s the real difference between the two anyways?
The key difference between a TFSA and an RRSP is that a TFSA uses what’s referred to as after-tax dollars, while an RRSP uses before-tax dollars. When you contribute funds to an RRSP, you get to deduct that contribution amount from your next year`s net taxable income on your tax return. In other words, you (temporarily) avoid paying taxes on that contribution amount, until you cash the RRSP upon retirement. Which means that a good portion of the benefit of an RRSP is used at the time of the contribution. An RRSP contribution is therefore a tax break.
On the other hand, a TFSA contribution doesn’t receive any special tax treatment. It’s considered after-tax because whatever contribution you make is made using funds that have already been taxed as ordinary income. The tax-free part of a TFSA involves the interest – all interest, dividends, capital gains, etc. earned in a TFSA is completely tax free, forever, as long as the money stays inside the TFSA.
There are some other differences that were discussed in the previous post. But the aforementioned difference drives most of the strategy involved with RRSP vs TFSA contributions. A big part of the benefit of an RRSP is immediate; that is, the current tax deduction on your next income tax return. This tells us a lot about whether to contribute immediately to an RRSP. If you are young, and you expect your income to increase substantially within the next few years, it may be smarter to wait for a few years to make your RRSP contribution, because the tax break you will receive is greater if your marginal tax rate is higher. As was discussed in the previous post, your contribution room grows over the years if you haven`t used it up previously. Furthermore, if your income is low right now, and your tax bill is very small to begin with, making contributions to your RRSP can be detrimental to your financial position. You’ll get a income tax deduction, but if you’re barely paying any taxes now, what use is that to you? Better to just invest your savings in an unregistered account and save your RRSP contribution for future, higher earning years.
Does the same concept apply for TFSAs? Absolutely not. As long as you’re paying even a dollar of tax, a TFSA will lower your taxes immediately. Furthermore, since there’s no immediate income tax deduction for the principle amount invested in a TFSA, it makes no difference whether you save your TFSA contribution room for now or later. In fact, in my opinion, every person should have maxed out their TFSA contribution already. That’s $5,000/person for 2 years running now. The only reason why your TFSA shouldn’t be used up is because all your savings are already being kept in another registered account, such as an RRSP or RESP.
If you are already earning a high income and your marginal tax rate is relatively high, then it perhaps makes more sense to use up your RRSP room before your TFSA room. If all your RRSP room is used up and you still have savings left over to invest, then start on your TFSA.
Anyways, point is, if you haven’t set up a TFSA yet and have some money in the bank in a savings account, go to the bank immediately and set one up.
The next question is, how should you invest your TFSA or RRSP money? Should your riskier, potentially higher-earning investments be put in a registered or unregistered account? The experts are pretty much divided on the issue. For investments that are safer and steadier, some experts believe that it’s better to put them in a registered account, since 1)it’s guaranteed to produce taxable gains, interest, dividends, etc. (as opposed to riskier investments, which can lose money in any given year) and 2)because the fact that it’s steadier means that taxes affect it more in the long run. Other experts believe that simply higher earning investments have the obvious potential for higher taxes (since the gains can be much greater), and therefore it’s better to put your riskiest investments in a registered account.
Personally, I think it’s completely your choice. The most important thing is that you are saving money and putting it away. That’s 90% of the battle. Obviously you should ask your financial advisor for his opinion in any case.
One obvious point is: Remember when I told you that every family should have an emergency fund (at least) equal to 3-6 months of living expenses saved away in risk-free investments? Those funds should not be prioritized ahead of riskier investments in terms of placement in a registered account, because taxes will be minimal on those investments. Remember, RRSPs and TFSAs help you grow your savings in a more efficient manner, without taxes impeding them. If your investments are not focused on growth, than they should not be in your TFSA. Nonetheless, obviously if you have no other savings, you might as well put the emergency money in your TFSA, to gain whatever tax break is possible.
Next post, I will discuss Registered Education Saving Plans - stay tuned!
The key difference between a TFSA and an RRSP is that a TFSA uses what’s referred to as after-tax dollars, while an RRSP uses before-tax dollars. When you contribute funds to an RRSP, you get to deduct that contribution amount from your next year`s net taxable income on your tax return. In other words, you (temporarily) avoid paying taxes on that contribution amount, until you cash the RRSP upon retirement. Which means that a good portion of the benefit of an RRSP is used at the time of the contribution. An RRSP contribution is therefore a tax break.
On the other hand, a TFSA contribution doesn’t receive any special tax treatment. It’s considered after-tax because whatever contribution you make is made using funds that have already been taxed as ordinary income. The tax-free part of a TFSA involves the interest – all interest, dividends, capital gains, etc. earned in a TFSA is completely tax free, forever, as long as the money stays inside the TFSA.
There are some other differences that were discussed in the previous post. But the aforementioned difference drives most of the strategy involved with RRSP vs TFSA contributions. A big part of the benefit of an RRSP is immediate; that is, the current tax deduction on your next income tax return. This tells us a lot about whether to contribute immediately to an RRSP. If you are young, and you expect your income to increase substantially within the next few years, it may be smarter to wait for a few years to make your RRSP contribution, because the tax break you will receive is greater if your marginal tax rate is higher. As was discussed in the previous post, your contribution room grows over the years if you haven`t used it up previously. Furthermore, if your income is low right now, and your tax bill is very small to begin with, making contributions to your RRSP can be detrimental to your financial position. You’ll get a income tax deduction, but if you’re barely paying any taxes now, what use is that to you? Better to just invest your savings in an unregistered account and save your RRSP contribution for future, higher earning years.
Does the same concept apply for TFSAs? Absolutely not. As long as you’re paying even a dollar of tax, a TFSA will lower your taxes immediately. Furthermore, since there’s no immediate income tax deduction for the principle amount invested in a TFSA, it makes no difference whether you save your TFSA contribution room for now or later. In fact, in my opinion, every person should have maxed out their TFSA contribution already. That’s $5,000/person for 2 years running now. The only reason why your TFSA shouldn’t be used up is because all your savings are already being kept in another registered account, such as an RRSP or RESP.
If you are already earning a high income and your marginal tax rate is relatively high, then it perhaps makes more sense to use up your RRSP room before your TFSA room. If all your RRSP room is used up and you still have savings left over to invest, then start on your TFSA.
Anyways, point is, if you haven’t set up a TFSA yet and have some money in the bank in a savings account, go to the bank immediately and set one up.
The next question is, how should you invest your TFSA or RRSP money? Should your riskier, potentially higher-earning investments be put in a registered or unregistered account? The experts are pretty much divided on the issue. For investments that are safer and steadier, some experts believe that it’s better to put them in a registered account, since 1)it’s guaranteed to produce taxable gains, interest, dividends, etc. (as opposed to riskier investments, which can lose money in any given year) and 2)because the fact that it’s steadier means that taxes affect it more in the long run. Other experts believe that simply higher earning investments have the obvious potential for higher taxes (since the gains can be much greater), and therefore it’s better to put your riskiest investments in a registered account.
Personally, I think it’s completely your choice. The most important thing is that you are saving money and putting it away. That’s 90% of the battle. Obviously you should ask your financial advisor for his opinion in any case.
One obvious point is: Remember when I told you that every family should have an emergency fund (at least) equal to 3-6 months of living expenses saved away in risk-free investments? Those funds should not be prioritized ahead of riskier investments in terms of placement in a registered account, because taxes will be minimal on those investments. Remember, RRSPs and TFSAs help you grow your savings in a more efficient manner, without taxes impeding them. If your investments are not focused on growth, than they should not be in your TFSA. Nonetheless, obviously if you have no other savings, you might as well put the emergency money in your TFSA, to gain whatever tax break is possible.
Next post, I will discuss Registered Education Saving Plans - stay tuned!
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