Optimizing RESP Contributions

Suppose you’re in the happy position that Grandma has offered to fully fund your child’s RESP with $50,000.  The big question is whether you should put the entire $50,000 into the RESP right away or spread it out over time to maximize the government grants.  David Chilton asked for my thoughts on this question when he interviewed me for his podcast.

To begin with, let’s make sure this really is a math problem.  If you choose to spread the RESP contributions out over time, how will Grandma react?  Will she say “If you’re not going to put it all in the RESP, I’m not giving it to you.”?  If so, then your choice is made for you.  We’ll assume here that Grandma doesn’t mind if you spread out the RESP contributions.  We’ll also assume that your child is young enough that there is time to spread out contributions before post-secondary education starts.

Overview of RESP rules

The lifetime limit of total RESP contributions for one child is $50,000.  Each year you contribute to an RESP, the government will match 20% of your contribution with a grant of up to $500.  So, the first $2500 you contribute in a year gets grant money, but anything above that gets no grant.  The total grant money is capped at $7200.

Possible strategies

1. At one extreme, you could make the $50,000 RESP contribution right away and get only one $500 government grant.

2. At the other extreme, you could make a $16,500 contribution right now, then $2500 more each year for 13 years, and then a final contribution of $1000.  This strategy gets the maximum total grant money of $7200.

3. Between these extremes is the strategy of making a starting contribution larger than $16,500, but less than $50,000, that will get less than the maximum grant money.

To find the best strategy, we need to know what you’ll do with the money that sits waiting to go into the RESP.  Let’s call this the side pot.

Side pot in cash

Suppose the side pot of money waiting to go into the RESP sits in cash earning no interest, and the RESP investments make 6% each year.  The following chart shows the final RESP portfolio value after 18 years across the full range of contribution strategies:

The best strategy turns out to be to contribute $42,500 to the RESP in the first year, add $2500 more in each of the next 3 years, and let the investments ride for the remainder of the 18 years.  This makes sense because it takes 4 years before the 6% annual RESP growth exceeds the 20% government grant.

However, if you’re worrying about optimizing RESP contributions, then you’re certainly not going to let a large sum of perfectly good money sit around in cash earning no interest for years.

Side pot in a TFSA

This time, let’s assume that you have substantial TFSA room available.  For this scenario, it’s important that you wouldn’t have used this TFSA room otherwise.  If using your TFSA for an RESP strategy stops you from using your TFSA for other purposes, then we’d have to take this cost into account.  For now, let’s assume that there is unused TFSA room available.

Suppose that the TFSA money is invested the same way as the RESP is invested, and that any of the returns on Grandma’s $50,000 remaining in the TFSA after 18 years will go toward the child’s education.  Let’s refer to the RESP balance after 18 years plus the remaining returns on Grandma’s $50,000 the final portfolio value.  The following chart shows the final portfolio value when the side pot is in a TFSA:

In this case, the best strategy is to go for the maximum government grant money by contributing $16,500 to the RESP initially, then $2500 per year for 13 years, and a final contribution of $1000.  This makes sense because the RESP and TFSA earn identical returns; the only difference among strategies is the amount of grant money.

Side pot in a taxable investment account

Now, let’s assume that Grandma’s money waiting to go into the RESP is in a taxable investment account.  We’ll assume that both the RESP and taxable account investments make 6% (nominal) per year, but you pay an average 30% tax on the side pot investment gains (interest, dividends, and capital gains) each year.  Again, we assume the remaining gains on Grandma’s initial $50,000 that remain in the taxable account will go toward the child’s education.  

The following chart shows the final portfolio value when the side pot is in a taxable account that gets taxed at 30%:

In this case, the best strategy is to contribute $35,000 to the RESP initially, then $2500 per year for 6 years.  But notice that if the starting contribution is anywhere from $30,000 to $40,000, it makes a difference of less than $500 to the final portfolio value.

Next, let’s assume you’re in a lower tax bracket.  With the bulk of returns as dividends and capital gains, you might only average 15% tax each year on the returns in a taxable account.  The following chart shows the final portfolio value when the side pot is in a taxable account that gets taxed at 15%:

In this case, the best strategy is to contribute $25,000 to the RESP initially, then $2500 per year for 10 years.  But notice that if the starting contribution is anywhere from $16,500 to $32,500, it makes a difference of less than $500 to the final portfolio value.

Conclusion

It’s clear that the best way to manage a $50,000 RESP gift depends on a number of factors, including investment returns, tax rates, and the availability of room in other tax-advantaged accounts, such as TFSAs or RRSPs.  Fortunately, getting this approximately right is fine.  If you make some reasonable assumptions and work out the best strategy based on those assumptions, you likely won’t go too far wrong.