Nancy Woods at Globe Investor answered a reader question about an RESP for his newborn grandchild: “does it make more sense to contribute a lump sum and forgo the government grant (CESG) or do I make annual contributions and take the government’s free $500? Signed Bill”. Unfortunately, her analysis failed to find the best option.
This question only matters if Bill actually has $50,000 (the maximum total contribution RESP amount) available right now. So, he either throws it all into the RESP now or he puts a certain amount in each year and invests the amount held back in a non-registered account.
The advantage of the lump sum right now is longer tax-free compounding. The advantage of spreading out the contribution is that each year the government will match 20% of the contribution up to a maximum of $500 per year and a lifetime maximum of $7200. (There are also catch-up provisions, but they are not relevant in this case.) Woods concludes that Bill has two options:
1. Make a $50,000 contribution right away and get only one $500 government grant.
2. Maximize the government grants by making a $16,500 contribution in the first year, then $2500 more each year for 13 years, and a final year’s contribution of $1000.
Assuming a 5% annual investment return (tax-free in the RESP and taxed in the non-registered account), option 1 leads to an RESP balance of over $121,000 when the grandchild turns 18, but option 2 only gives $119,000 in total between the RESP and non-registered account.
Woods concludes that tax-free growth trumps the government grants by a small margin. However, she fails to consider the best option, which is somewhere between options 1 and 2. To see what I mean, consider the strategy of making a $47,500 contribution right away and $2500 the next year. This would get $1000 in government grants. Compared to option 1, this strategy loses out on one year of 5% tax-free growth on $2500 but makes 20% on this $2500 with a government grant. This is clearly better than option 1.
Even better would be if Bill makes an initial $45,000 contribution right away and $2500 for 2 years. No doubt you can see where this is going now. The best answer is for Bill to make a sizeable initial contribution and then $2500 for several years until he reaches the maximum $50,000 lifetime maximum. The optimum number of years of smaller contributions depends on the rate of return assumptions and Bill’s marginal tax rate.
If we assume a 5% investment return and a 40% marginal tax rate, Bill’s best option is a $35,000 initial contribution and $2500 more each year for 6 years. This gives Bill’s grandchild a final total of over $124,000 at age 18. The best strategy will vary with the return and tax assumptions, but one thing is certain: contributing an initial lump sum of $50,000 is not optimal under any sensible assumptions.