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We write a lot here on this blog about retirement, but one area I haven’t covered at all up to now is saving for your kid’s university education (or college, as you Yanks like to call it). The reason for this is simple: we don’t have kids, so we never looked into it.
But lately, we’ve decided to set up a university savings account for my nephew, and because this forced me to learn how all this stuff works, I figured now would be a good a time as any to start writing about it.
How It Works
So first things first. How does all this crap work?
In Canada, we have what’s called a Registered Education Savings Plan, or RESP. In America, this is called a 529. As usual, the name for the American account provides absolutely no hint as to what it’s supposed to be used for. Way to go, guys.
In both countries, the basic idea is that you contribute money into it while the kid’s young, you invest it in a low-cost Index-hugging ETF-based portfolio. Then when the kid goes to university and needs to pay tuition, he or she withdraws it. The withdrawals become taxable income attributed to them, but since 18-year-olds rarely have any income, it’s generally withdrawn tax-free.
For the RESP, contributions are not tax-deductible, so all contributions are done with after-tax money. For the 529, contributions are not tax-deductible at the federal level, but depending on which state you reside in, state tax may be deductible.
Also, in Canada, RESP contributions are matched by the federal government at 20% through a program called the Canada Education Savings Grant, or CESG. CESG payments are capped at $500 per year, so it generally doesn’t make sense to contribute more than $2500 a year since you wouldn’t get any more matching. This matching doesn’t exist for Americans. *sad trombone sound*
So knowing this, is an RESP or 529 plan worth doing? That’s a much longer debate for another article, as the American one is far less attractive since if you live in a state with no state tax deduction, the thing is basically a glorified Roth IRA with more restrictions on what you can and can’t spend it on.
But for the Canadian RESP, the answer is generally yes. By putting money into the RESP, you’re getting an automatic 20% ROI right off the bat! What other investment can you make a guarunteed 20% return on?
The Rule of 5
OK so now that we’ve covered the basics of RESP’s and 529’s, let’s discuss what we should do with the money once it’s in the account.
Generally, when people ask me which portfolio they should build in their 401(k) or a Roth IRA, I tell them to treat all their investment accounts, including 401(k)/RRSPs, and Roth IRA’s/TFSA’s, as one giant portfolio. Design your portfolio according to your individual risk tolerance and investment timeline, then figure out which ETFs should go into which accounts for maximum tax efficiency.
The RESP/529 is different. These funds are earmarked for a very specific purpose, and more importantly, we know exactly when the first withdrawal will be needed. This means that this account actually has a different risk tolerance than your normal risk tolerance, and as a result should be managed as its own seperate portfolio.
Remember that the most important factor in determining a portfolio’s equity/fixed income allocation is your investment timeframe. If you don’t need the money for a while (say, 15+ years), you should generally have a higher equity allocation. If you’re closer to retirement and will need to start withdrawing soon, you should have a higher fixed income allocation to smooth out the volatility.
And RESP/529 accounts actually have a really well-defined withdrawal schedule. You don’t need to make any withdrawals (and are generally not allowed to without paying some kind of penalty) until the kid turns 18 (the normal age for graduating high school). Then you need to withdraw the money rapidly as cash over the next 4-5 years (assuming this money is used to pay for an undergrad degree).
This knowledge means we can create a really simple formula to determine your RESP/529 portfolio’s asset allocation. I call it the Rule of 5.
Here’s how it works.
Take the kid’s age. Multiply that number by 5. That’s how much fixed income your portfolio should have.
What this will do is cause this portfolio to be 100% equity at the beginning. Yes this sucker is going to be volatile but remember, the S&P 500 has never lost money in investment periods over 15 years, with a median return of 11%, so if you know for certain that your investment timeframe is more than 15 years, you want to cowboy it up.
Then, as the kid gets older, 5% gets rebalanced every year from the equity side to the fixed income side. This will gradually make the portfolio more and more conservative over time as the withdrawal period gets closer.
When the kid turns 18, their portfolio will be 10% equity/90% fixed income, which is extremely conservative as they start their withdrawals.
Then when the kid turns 20 (halfway through their degree), their portfolio will be 100% fixed income. After that, they just sell of their bond ETFs as they need the money, withdraw it, and then melt the portfolio down.
This is what a “Rule of 5” portfolio looks like over time.
| Age | Equity | Fixed Income |
|---|---|---|
| 0 | 100.00% | 0.00% |
| 1 | 95.00% | 5.00% |
| 2 | 90.00% | 10.00% |
| 3 | 85.00% | 15.00% |
| 4 | 80.00% | 20.00% |
| 5 | 75.00% | 25.00% |
| 6 | 70.00% | 30.00% |
| 7 | 65.00% | 35.00% |
| 8 | 60.00% | 40.00% |
| 9 | 55.00% | 45.00% |
| 10 | 50.00% | 50.00% |
| 11 | 45.00% | 55.00% |
| 12 | 40.00% | 60.00% |
| 13 | 35.00% | 65.00% |
| 14 | 30.00% | 70.00% |
| 15 | 25.00% | 75.00% |
| 16 | 20.00% | 80.00% |
| 17 | 15.00% | 85.00% |
| 18 | 10.00% | 90.00% |
| 19 | 5.00% | 95.00% |
| 20 | 0.00% | 100.00% |
Generally, I’m planning on using the same ETF’s that I used for our Investment Workshop. The fixed income portion will be covered using the bond index ETF VAB, and the equity portion will generally be split evenly among the Canadian, American, and International stock market indexes using VCN, VUN, and XEF.
Every year, as more cash gets deposited into the account, we’re planning on using this Rule of 5 to calculate our new target portfolio and we’ll simply rebalance it until it’s on target again. At first we’ll probably be able to do this by just redirecting our cash buys, but later on we’ll probably have to sell ETFs from the equity side and put it towards the fixed income side. Which is fine, since investment income including capital gains are tax-free in this account, so I can do whatever transactions I want and I’ll never have to worry about incurring a taxable event.
So there you have it. That’s how we’re planning on managing this RESP account. What do you guys think? Do you agree with the Rule of 5? If not, how are you planning on investing for your kid’s education? Let’s hear it in the comments!
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Thank you for this article. I too plan to save money for my niece’s education and plan to use an RESP in order to benefit from the guaranteed 20% return. I love the Rule of 5 and will implement it into my investment strategy for her!
You opened a university savings account for your nephew? That’s kind of unusual. Are his parents not able to save?
How much are you putting into the account?
Oh they can save just fine. I’m just helping them manage the account since investing is kinda my thing, plus the occasional gift for birthdays and what not.
That’s a pretty cool strategy!
Any idea on what the average 4-year undergrad degree would cost in Canada assuming kids stay at home? I should have about $170K for my 2 kids in approx. 12 years when my oldest attends first year university. Will this be enough?
N1, look up the cost of a degree at the Universities closest to where you live. It is always cheaper to send your kids to a University in the same province, out of province they can slap on higher tuition. It also depends on the subject matter (general BA vs something specific like Engineering) and the University itself. I looked into a general BA as a benchmark and it’s about $7k-$8k a year for tuition, + books/transit, etc you could estimate $10k per year or $40k for a degree. If you send your kid away, it’s about $100k for a 4 year university degree. Given what you’ve saved, you’ll have about $90k leftover which means your kids could also get a college certificate or go to Grad school. And also depending on the Uni, some have automatic scholarships so if your kid has an 85%+ average they can get up to $10k covered over the 4 years.
Quite a bit less in QuĂ©bec though. Bachelor’s degrees are 3 years here at about $3500 to $4000 (depending on specific course fees and if you take health insurance etc.). So 11-12K for tuition over 3 years. A bit over twice as much if you come from another province.
Adam, that is true. I live in Ontario so I was quoting costs for that province. Quebec still has Grade 13 so that’s why only 3 years of Uni is required to get a degree. I was looking into Montreal universities for my daughter and it is more experience for us because she would be out of province. About +$3k per year (higher than Ontario) if I recall correctly. Getting a degree if you are from Quebec is a real steal! You have to live there for about 2 years before you can take advantage of the cost savings though.
*expensive*
Yeah but then you’d have to learn French. *shudder*
Ha ha! The funny thing is McGill and Concordia are filled with non French speakers from other parts of Canada and the US. Classes are in English. The issue is it is unreasonably expensive to send a kid there if you aren’t a resident of Quebec. Better off sending them to a good school in Ontario.
Yup, university is another area where Quebec is a good deal (others being housing, day care, electricity, and car insurance). I finished my B. Comm. at Concordia last December, and even having spread the thing out part-time over six years and needing additional classes due to changing majors, the whole degree cost about $20k.
As was mentioned, if you’re a Quebec resident, you save firstly because you’re only paying for 3 years instead of 4. CEGEP – the two years between Grade 11 and university – are essentially free. Then you save again because the tuition is roughly half what it costs in Ontario. My guideline years ago was about $3,000/year including books, assuming a full-time course load. $3,500-$4,000 today sounds right to me.
I’ve known quite a few students who came to Montreal from out of province, and all have found it to be a positive experience. Exposing young people to an additional language is never a bad thing, and Montreal is an amazing city for young people – lots of night life, high quality schools, very accessible public transit, and a large variety of different cultures and experiences.
Using U of T as a benchmark, an Applied Science bachelor’s degree will cost $15k per year. So a 4 year program will cost $60k. So your $170k target should be more than enough. Hell, you might want to slow down your contributions since you only need $120k.
Check it out:
http://www.planningandbudget.utoronto.ca/Assets/Academic+Operations+Digital+Assets/Planning+$!26+Budget/tuition1819.pdf
We do our 529 allocations very similarly, but about 20% less conservative. That is, shift everything 4 years later. 0% bonds at age 4, 70% at age 18 when will enter college, and will never quite reach 100% bonds. Great minds think alike, we just have different risk tolerances. 🙂
Coolio. What 529 provider do you use?
We’re in Maryland, so use our state’s T. Rowe Price 529 plan. They added some index funds earlier this year. Not exactly the low E.R.’s of Vanguard, but still pretty good.
Sounds like a very reasonable strategy, although I think mixing in some GICs with your bonds for the fixed income portion when you’re within 3-5 years of withdrawal time to lower volatility even further would be a good idea.
Good idea. A few years out I think I’m going to convert my bond ETF into a bond ladder.
What do you think about making a lump sum contribution to the RESP of about $14,000 early on if available so that those funds can grow in the account and you can max the full contribution limit of $50,000?
Any contributions above $2500 don’t make sense since you no longer get the CESG payment, plus you’d use up your lifetime contribution limit.
If you have extra funds, invest it a TFSA. Then every year, withdraw $2500 from the TFSA and move it into the RESP.
Can we open RESP using questrade? I have my sons RESP with sunlife and I think it would be better off with the Vanguard funds.
Yup. That’s the provider I used for my RESP.
Any thoughts on contributing $14,000 early on to the RESP to allow it to grow sheltered and still be within the $50,000 contribution limit?
$2500 *14.4 = $36,000 over 14.4 years to receive the maximum Canada Education Savings Grant of $7,200. $50,000 minus the $36,000 means $14,000 that could be dropped in the account early on to grow from 0 to 18+. Seem like a good plan, or better to invest it outside the RESP to keep it flexible?
It makes no sense to contribute over $2500 into an RESP since you don’t get the CESG plus you have restrictions on withdrawing it. If you have the extra money, invest it in a seperate TFSA.
Hey Wanderer,
The math is super easy to follow for one kid – what’s your suggestion for family RESP’s though – how would that impact the timing of when you hit 100% fixed income – at 20 for the oldest kid, the youngest kid, or somewhere in the middle? My thought is it’s dependent a little on your risk tolerance as well as the significance of the age gap between kids, i.e. only 2 kids with 2-3 years apart it’s practically a moot point, but then there’s always the surprise baby years later lol, or those with a lot of kids!!
Also, if you are low income or middle income (the top of middle income is nearly $100k) you can apply for an extra $50 (middle income) or $100 / year (low income). It doesn’t change the total $7200 total the gov’t will give you over the child’s RESP lifetime, but could speed up the timing a little, and we all know about the sweet impact of compounding.
Good point on the extra CESG payments for low/middle income families.
As for multiple kids, I’d open up a seperate RESP for each kid. Otherwise the math gets super confusing.
The family RESP provides for individual accounts, all under the same family umbrella. If one of your kids doesn’t use thier share, the funds can be allocated to your other children.
I’m glad you write a lot on your blog about ways to create diversified streams of income and about healthy financial retirement because like yourself, I too hate getting up in the morning and going to work. I’d rather take a chance and start my own business. I’m glad to support your blog because you always write something thought-provoking and inspire people to be their own boss with the hope of being a future side hustle millionaire. 🙂
Perfect timing guys, as i almost reached the max contributions to my child’s RESP and thinking of next course of actions. Here is my 2cents on this topic.
I have started contributing from 2013 (9th year of my child) (retro payments) of 5k each year. By 2019 i will finishing the max contribution limit to get govt. grants.
Total grants allowed by govt is $7200 (CESG+Additional CESG (below 45k income)+CLB) which needs $33,250 (my case but it might be different for other having higher income)
Currently the RESP is with CIBC Income Plus where principle amount has allotted in Money Market fund and 20% govt. grant has split half into “Global Monthly Income” and “Dividend Growth” funds which has 50-50 FI/EQ allocations.
I know, 40k is not sufficient for kids undergrad education in Ontario(counting the inflation) by 2022,
i invested another $60k in a condo (Kitchener) yielding more than 12%/annul return (Rent $2.4k ($200/month)+contribution to mortgage principle $6k($500/month) in addition to price appreciation (conservative 2% per annul). when the time comes to spend beyond $40k, i will sell the condo and use the proceeding towards either education or some other activity which not restricted by RESP withdrawal rules (assuming if my child wants to study abroad where RESP might restrict…heard some stories on this front).
Well, this may or may not a good strategy, but it might work if Real estate returns more than 12% conservatively.
Mak,
What kind of U.S. government grants are you talking about? 🙂
Hi DNN,
I am talking about Canadian govt grants. This article is about RESP account which is Canadian educational investement vehicle.
Total grants allowed by Canadian govt is $7200 (CESG+Additional CESG (below 45k income)+CLB) which needs $33,250
Really glad you wrote this, as we have two 14-month olds and just opened 529s for them. We were wondering how our equity/bond balance should be set up and I think you’ve answered our questions.
Another area where Quebec shines for education, the Quebec governement match the RESP contribution at 10% for the first 2500$. Which mean an automatic 30% of ROI for an RESP contribution.
In Wisconsin, our 529 plan has great tax benefits due to the loopholes built in the plan. In Wisconsin, I can contribute up to $3200 per beneficiary this year a deduct this from my state income taxes. Where this can be exploited is the definition of beneficiary and how I can transfer beneficiaries after I make the contribution. In my case, I can contribute $35,000 to my children’s college fund and take the state tax deduction on that whole amount. By dividing the contributions between my wife and I and then dividing it between our children we can be under the federal yearly contribution limit for gifts. I plan to front load my contributions for my children ages 1 and 4 and let it grow tax free until they reach college age in order to maximize the tax benefits while reducing my state income taxes this year by $2000. I could also qualify for the rebate from the California 529 plan on 529 day.
Hey Wanderer,
Can you comment on tax efficiency strategy like you mentioned in your post below:
https://www.millennial-revolution.com/invest/how-to-pay-no-tax-on-your-investments/
Apparently, US dividends are also withheld according to the following article:
https://www.moneysense.ca/columns/ask-moneysense/claim-withholding-tax-from-u-s-stocks-and-how-to-get-it-back/
Should we just follow the same strategy you suggested in the your blog post and treat the asset classes for RESPs the same as RRSPs?
We used to put money in 529’s for our kids, but never liked all of the rules attached.
Upon our early retirement set for less than 2 years, we are planning to move to Spain and if things go well I can see the kids eventually going to College in Europe where it tends to be much cheaper. They are still really young though (only 5 and 7) and so things can change.
I wish I knew about the side hustle 20 years ago because if I did and I had kids today, I will be well prepared ahead of time to pay for college without doing anything else.
Interesting perspective but the uncertainty over how the costs of education will rise is not taken into consideration, isn’t it? That’s what keeps me anxious whenever I sit down to redo my portfolio, especially when student loans are getting pricier. Plus my kid does not seem to be the brightest so there’s that.
But the rule of 5 makes sense if you do not have any other plans and are taking a no-holds-barred stand. Will try to incorporate it into my strategy. Thanks.
The rule of 5 seems like a great idea and we will definitely use it when saving for our children’s education.
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