The beauty of tax-free savings accounts is their simplicity. You put money in, watch it grow tax-free and take it out whenever you want, also tax-free. That’s it.
That’s why Canadians are using TFSAs for all kinds of things: saving for retirement, emergency funds and short-term goals like saving for a down payment or a vacation. But there’s another possible use, financial planners say: setting extra money aside for your kids’ education.
Registered education savings plans are meant to help families save for post-secondary education and come with generous government grants. But a TFSA can be a good place to put any funds you may be able to save in addition to what goes into an RESP, said Markus Muhs, investment advisor and portfolio manager at Canaccord Genuity Wealth Management in Edmonton.
The rationale for using up some of your TFSA contribution room for your kids is that what you save in an RESP may not be enough to cover all their higher education costs. And Canadians don’t get to open their own TFSA until the age of 18.
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The classic strategy for RESPs is to contribute $2,500 a year. That maximizes the government’s 20 per cent top-up, which is capped at $500 per year (although additional grants are available for low-income families and B.C. residents).
With a respectable average annual return of six per cent per year, those contributions and grants would grow to around $90,000 after 18 years. That may seem like a lot, but if higher education costs keep increasing at four per cent per year, as they have for decades, it may be barely enough to cover tuition and books for a four-year degree, Muhs estimates.
Parents who want to pay for room and board — or graduate school — would have to save more, said Rona Birenbaum, a financial planner and founder of Toronto-based financial planning firm Caring for Clients.
“What we are recommending a lot of clients do, is do the $2,500 a year to the RESP and then do another … $2,500 a year into a TFSA.”
The annual RESP contributions are meant to capture the government grants, while the TFSA savings provide funds that can be tapped tax-free and with no strings attached, she noted.
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Unlike with TFSAs, some RESP withdrawals are taxable. You can think of RESP funds as belonging to two buckets, one made up of contributions, on which you’ve already paid tax, and one made up of the grants and investment returns earned over time. Withdrawals from the second bucket are taxable in the hands of your child, although since students typically don’t earn much, there may be little, if any, tax payable.
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Still, the RESP should remain families’ first go-to for education savings, both Muhs and Birenbaum said.
“I would never recommend a TFSA as a replacement for the RESP,” Muhs said.
Even if your kid happens to be making money and is in a high tax bracket when the RESP money comes out, the added government grants make up for the tax loss, Muhs added.
It’s also important to know that the money you save in an RESP doesn’t necessarily have to be used for university. You can tap it to fund most kinds of post-secondary education, from college to trade school. It’s also possible to use the money to pursue higher education abroad.
Parents who can afford to put away more than $2,500 a year into an RESP may want to consider a few alternative contributions strategies.
The lifetime contribution limit for the account is $50,000, which works out to more than $2,500 a year. Also, the total amount of federal grants (excluding the extra funds for low-income households) is $7,200. This means the annual contributions of $2,500 hit the grant cap in year 15, leaving about $15,000 that isn’t eligible for government top-ups.
One option is to contribute $50,000 over the first 15 years, or $3,333 per year. This captures the government grants while front-loading the contributions, which gives your money more time to grow tax-free. With a six per cent average annual return, you’re looking at more than $112,000 by age 18.
A more aggressive front-loading option is to contribute $15,000 when your child is born and then $2,500 per year for the following 14 years. Using the same math, the account would grow to nearly $134,000.
But under the same assumptions, the best option, if you can swing it, is contributing $50,000 at the start, according to Muhs. While you’d get just $500 in grants, your lump-sum contribution could grow to $144,000 over 18 years, with the investment growth potentially more than making up for the $6,700 in forfeited government money.
Still, both Muhs and Birenbaum said few families can afford to maximize education savings, let alone pour extra funds into a TFSA. And parents should always take care of their own retirement goals and debt-repayment needs before thinking about helping their offspring pay for school.
A high school graduate with enough RESP funds to cover half of post-secondary education costs can work or take out student loans to make up for the shortfall. But aging parents with a 50 per cent shortfall in their retirement savings are going to have a much harder time bridging that gap, Muhs said.
When it comes to RESP savings, “usually it’s a nice boon having anything.”
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