I thought it would be worthwhile to touch on the subject of RESPs given that this past summer we had to make our first RESP withdrawal as our daughter entered her first year of post secondary education.
Where to Find Reliable Information on RESPs
The intent of this article is not to review the intricacies of RESPs but rather to discuss the rationale for why we chose to go with a self directed RESP and the reasoning for the investment decisions we made. I, however, provide various links to the Government of Canada’s site throughout this blog. These links take you to pages on the site which contain a wealth of information on RESPs in the event this is a foreign subject matter to you.
I encourage you to visit the section of the site which specifically addresses the annual and lifetime contribution limits including details about the two types of grants available to Canadians (this is in essence “free money” from the Federal Government so don’t pass it up….okay, it is not really free money since some of your tax dollars probably end up in the “RESP grants kitty”).
The two grants which are available are the Canada Education Savings Grant (CESG) and the Additional Canada Education Savings Grant (A-CESG). The latter is money provided by the Government of Canada for Canadian children from low-income and middle-income families.
In addition to the two available grants, there is the Canada Learning Bond. On the following site you will find a link which will take you to the site where you can determine if you qualify for this additional form of funding.
Should you reside in the province of Saskatchewan or British Columbia, you may want to check the following site as these two province offer additional funding.
The Canada Revenue Agency also has a section of their site that will likely be of interest to you.
What to Look for from a RESP Provider
There are a host of options from which to choose when establishing a RESP so carefully choose a RESP provider who can:
- advise you on how to choose the right RESP which would include details related to service fees, limits on contribution frequency and amounts, penalties, payment options and other requirements
- provide guidance on investment options; mutual funds, stocks, guaranteed investment certificates, term deposits or savings accounts carry different risks and rates of return so make sure the provider clearly spells out details on the investment options that are of interest to you.
- administer your RESP
- provide the funds when your child is ready for post-secondary school
Why We Went With a Self-Directed RESP
When it came time for us to establish a RESP for our daughter in 1999, we wanted the ability to:
- manage the funds
- minimize fees
- acquire investments which would provide us with the opportunity to earn returns in excess of the rates typically generated through relatively safe but low yielding term deposits and GICs.
In addition, we had no desire to invest in mutual funds because we are of the opinion that the mutual fund fee structure in Canada is beyond reasonable. In addition to the Management Expense Ratios (MERs) there is a host of other fees charged by mutual fund companies. I encourage you to quickly review the following sites so you can get an idea of all the fees charged by fund companies; these fees are levied by the fund company even if the fund underperforms the benchmark!
The following link takes you to a study by Investor Economics for The Investment Funds Institute of Canada September 2012. While 65 pages in length, a quick review of this study indicates there is a host of fees charged by fund companies!
If you think about the infrastructure of a fund company and all the overhead it must incur, you quickly come to grasps with all the fixed and variable costs that must be serviced. From where do you think the fund companies are going to generate the revenue to cover all their expenses?
It is for these reasons that we decided to go the route of a self directed RESP.
On an annual basis we contributed the maximum permissible under the RESP rules so as to receive the maximum CESG. We informally set out an investment policy that outlined the types of companies in which we could invest; we restricted our investments to good solid companies with a lengthy record of paying increasing dividends such as the major Canadian banks, insurance, and telecommunication companies. No speculative investments were permissible.
Our Investments Within the RESP
Fast forward to the Fall of 2007. I was becoming increasingly concerned about the real estate market in the US and the impact any implosion could have overall. I vividly remember watching a video in which a young couple with several children under the age of 10 (one was still in a stroller) was featured. Both the mother and father worked menial jobs and the combined annual household income was extremely low (I think it was less than USD$45,000). They were interviewed in their new home (I think it was in excess of USD$350,000) yet they had not even sold their previous house which they had purchased just a couple of years previously. Both homes had been purchased with 100% financing and, clearly, the mortgage on the first property had not been fully repaid.
Another video that set off alarm bells was one in which a young gentleman in his early 20s was being interviewed. He had managed to acquire multiple properties for “investment purposes” yet he had no net worth of any significance and his income was negligible at the time he had applied for mortgages to acquire these “investment” properties. At the time of the interview, he had essentially lost everything and had to declare personal bankruptcy because the income he was expecting to generate from the properties fell short of his debt service obligations; some tenants lost their employment and could not meet their rental obligations which had a snowball effect.
This is when I truly became aware of the extent of the proliferation of subprime mortgages. Prior to this, I had never heard of people financing 100% of the purchase price plus closing costs, nor the terms “adjustable rate mortgages”, “liar mortgages”, “NINJA (No Income NO Job) mortgages”, and mortgages where the payments were insufficient to cover the accruing interest (the shortfall between the interest owing and the payments made would merely be added to the mortgage. Theoretically, when you sold your house at a later date, the increase in the value of the property would be sufficient to repay the mortgage.
When I heard that these individuals were not isolated cases, I thought “something is not right”. I became increasingly nervous so I liquidated the investments in our daughter’s RESP and sold a large percentage of our investments in other self directed accounts fearing there would eventually be a “spillover” effect into the equity markets.
The markets did experience a major correction in 2008 and early 2009 and in the Spring and Summer of 2009 we deployed the funds which had been sitting in cash. In the self directed RESP we acquired shares in the following companies:
- Intact Financial Corporation (TSX: IFC)
- Sun Life Financial Inc. (TSX: SLF)
- Paychex, Inc. (NASDAQ: PAYX)
- Intel Corporation (NASDAQ: INTC)
We chose to invest in these companies because they were financially sound, had a dividend policy which appealed to us, and the market conditions had depressed stock prices to the extent where we felt we were getting value. Although SLF subsequently had to freeze its dividend for several years, we were generating a dividend yield slightly in excess of 5.25% based on our purchase price and I was reasonably confident SLF would not cut its dividend.
In hindsight, we should have held Paychex and Intel in one of our RRSPs since there is no withholding tax on dividends earned on shares of US listed companies if held within a RRSP; there is a 15% withholding tax if held within non-registered accounts or RESP; there is no way of recovering these withheld taxes if held within a RESP. Despite this “faux pas”, these investments have panned out well. If I could get a “do over”, however, I would have restricted our holdings in the self directed RESP to stocks listed on the TSX.
In April 2016, we sold some investments and withdrew a $5,000 Educational Assistance Payment (EAP) for the purpose of making an initial payment to our daughter’s school; a T4A will be issued in our daughter’s name for tax purposes.
When it comes time for you to withdraw funds from a RESP, keep in mind that EAP withdrawals are limited to $5,000 within the first 13 consecutive weeks of enrollment in a Qualified Post-Secondary Educational institution in Canada and non-University Qualified Post-Secondary Educational institution (ie. College) outside of Canada. For students studying outside of Canada and enrolled full time in a University, the EAP limit is $5,000 within the first 3 consecutive weeks of being enrolled.
In August 2016, after the first 13 consecutive weeks of enrollment in a Qualified Post-Secondary Educational institution in Canada, we made a capital withdrawal from the RESP; this form of withdrawal is NOT taxable to the beneficiary (our daughter) or the subscriber (my wife and me). We will continue to make Educational Assistance Payment (EAP) and Capital Withdrawals for the next few years while our daughter attends school.
While we could have made contributions into a RESP until 31 years after first opening the plan but we reached our contribution limits a few years ago. Had we not done so and we had other RESPs for other children (we don’t have any other children) we could have transferred savings from other RESPs into a single plan. We would have then had until the end of the 35th year after the plan was first opened to use the funds before the RESP expires (this may not be permissible under the terms of every plan so be sure to inquire about this at the time you set up your plan).
A third form of withdrawal is one we hope we never have. This withdrawal is an Accumulated Income Payment (AIP) which may be taxable to my wife and me. It relates to any savings that remain in your RESP when it closes. In this case:
- money received from either the (CESG) or the (CLB) will be returned to the Government of Canada; and
- any personal savings in the account will be returned to the person(s) who opened the plan.
The interest earned on the personal savings and any government grants or bonds will be returned to you if all of the following apply:
- all children named in the plan are at least 21 years old and are not eligible for an Educational Assistance Payment;
- the subscriber is a Canadian resident; and
- the RESP has been opened at least 10 years.
When withdrawn, the money will be taxed at your regular income tax rate, plus an additional 20% (yikes!). You may also transfer these funds into a personal or spousal Registered Retirement Savings Plan (RRSP); we won’t be able to do this because we always maximize our annual RRSP contributions.
I strongly encourage you to speak with your RESP provider for more details and for explanations on any conditions or penalties that may apply to your RESP should you decide to close the account.
If you have absolutely no prior experience or very limited experience in investing, a self directed RESP is not the right strategy. It is highly recommended you learn to properly assess the credit quality of a company and how to determine whether the investment you are going to make has a reasonable probability of providing a reasonable return before you contemplate making your own investment decisions.
In a subsequent blog I will review our investment analysis process.
As always, I would welcome the opportunity to hear from you.