Q4 2024 – Newsletter Insights

it’s Back-to-School time…

The RESP: Would You Turn Down “Free Money”?

There are many reasons to consider a Registered Education Savings Plan (RESP) to save for a child’s future education: tax-deferred growth within the plan, earnings taxed at the child’s tax rate when eventually withdrawn and, of course, the Canada Education Savings Grant (CESG). The CESG consists of funds paid into the plan by the federal government as a 20 percent matching grant, to an annual maximum of $500 ($1,000 if there’s unused grant room from a previous year) and a lifetime maximum of $7,200 per beneficiary. There are no annual limits on RESP contributions, however the lifetime limit is $50,000.

Conventional wisdom suggests we should take advantage of the CESG — after all, it’s essentially ‘free’ money. But is this always the best decision? One way to maximize the CESG involves contributing $2,500 per year over 15 years to receive the full $7,200 in grants. However, will this achieve the greatest outcome for the RESP?

To answer this question, let’s compare Investor 1, who gradually contributes and maximizes the CESG, and Investor 2, who contributes a lump sum amount and doesn’t maximize the CESG. The outcome may be surprising. Both investors are assumed to earn an annual rate of return of 5 percent. Investor 1 contributes $2,500 each year starting in the first year of the child’s life until year 20, to a maximum contribution of $50,000, and receives the full $7,200 CESG grant. After 20 years, the RESP produces $43,655 of growth, resulting in a value of $100,855. Investor 2 contributes a lump sum of $50,000 — the full RESP limit — in the first year of the child’s life, so the RESP receives only $500 of CESGs. Yet, the RESP grows to $133,992 over the same period.

This shows the profound impact of compounding over time. Front loading the initial contribution yields a larger outcome, even without receiving the full CESG, all else being equal. Despite lower total contributions (funds paid into the plan plus CESGs) for Investor 2, or $6,700 less in CESGs, the outcome is $33,137 greater.

A Lesson for the RESP — And Investing in General

Of course, not many investors have $50,000 of discretionary funds at the start of a child’s life. As such, maximizing the CESG where possible is a prudent strategy. Yet, this example illustrates why, as advisors, we often remind investors not to overlook the impact that compounding can have over time on any investment — not just the RESP. One takeaway? The sooner you start, the more time funds have to grow and, when it comes to growth, the larger the initial investment, the better!

Illustrative: RESP Gradual vs. Lump Sum Contribution

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*Assumes 5 percent annual compounded growth.

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INSET:

When was the last time you reviewed account beneficiaries?

A recent article in the Wall Street Journal is a reminder: “His Ex Is Getting His $1 Million Retirement Account. They Broke Up in 1989.” Before year end, consider reviewing account beneficiaries, especially if you’ve left a job or had changing life circumstances. If you need assistance with investment accounts, please call.

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SURPRISING TFSA STATISTICS

Are You Overlooking the Tax-Free Opportunity?

There are few “gifts” that the government gives us, and the Tax-Free Savings Account (TFSA) is one of them. The opportunity to invest and grow funds on a tax-free basis over a lifetime should not be overlooked.

Yet, the latest statistics reveal that many high-net-worth (HNW) individuals are not taking full advantage. The 2024 TFSA statistics (for the 2022 tax year) were recently released and are surprising. For HNW taxpayers with incomes over $250,000, around 35 percent of average contribution room remains unused. While many of us gripe about higher taxes, we certainly aren’t doing a great job of maximizing tax-advantaged accounts. As well, the average fair market value (FMV) remains below the cumulative contribution limit. An investor who invested the full annual dollar amount since the TFSA’s inception could have over $145,000, assuming a rate of return of 5 percent each year.

What’s causing these shortfalls? Several factors might be at play. When the TFSA was introduced in 2009, it was often misunderstood as merely a ‘savings account,’ leading some investors to miss out on its growth potential. Others continue to view the TFSA as a short-term tool, withdrawing funds for immediate expenses rather than letting them grow. However, the opportunity cost is significant. Consider an investor who contributes the 2024 cumulative contribution limit of $95,000, plus $7,000 annually at a 5 percent rate of return over 25 years. This would accumulate to almost $650,000 in funds that could be withdrawn and used completely tax free! Yet, this assumes that contributions and investment gains are left untouched in the TFSA, allowing for growth.

Another factor may be that some investors have taken a more risky approach with their TFSA investments. This may be harmful for two reasons. If an investment realizes a substantial loss, that contribution room is lost forever. And, there is no tax relief. Unlike a non-registered account, TFSA losses cannot be claimed on an income tax return.

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How about you? Are you fully maximizing your TFSA? Don’t overlook the potential for significant future tax-free growth. Call for assistance.