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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The withdrawals become taxable income attributed to them, but since 18-year-olds rarely have any income, it’s generally withdrawn tax-free.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.
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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