A registered education savings plan (RESP) is a great way to save for a child’s post-secondary education. Not only do you get free money from the federal government for making a contribution, but any capital gains and investment income are sheltered from tax.
Before getting into the investment options, let’s do a quick overview of RESPs.
The funds can only be used to pay for a child’s education after high school, contributions aren’t tax deductible, capital gains and investment income earned are sheltered from tax until the funds are withdrawn, and the lifetime contribution limit for each child is $50,000. Also, the federal government and some provinces (British Columbia, Quebec, and Saskatchewan) will match a portion of your contributions up to a certain amount.
There are a number of investments you can choose from. Here’s a rundown of some of the most popular options:
Stocks: A stock is a share of a company. By owning a stock, you technically own a piece of a corporation. If you own Apple stock, for example, you’re a part owner of the company. Stocks are traded on exchanges, such as the Toronto Stock Exchange, New York Stock Exchange, or NASDAQ. You can purchase stocks through a discount brokerage.
Bonds: A bond is a type of debt issued by a company or government (federal, provincial, or municipal). By owning a bond, you own a portion of the issuer’s debt and will receive interest payments on a regular basis. Bonds aren’t traded on exchanges and are instead traded between investors. Bonds can also be purchased through a discount brokerage.
Mutual funds: A mutual fund in a type of investment that pools together money from a group of investors with the purpose of buying a variety of stocks, bonds, or other assets. Having an assortment of stocks or bonds instantly diversifies your portfolio. There are a number of funds available, including equity (stock), fixed-income (bond), balanced (a mixture of stocks and bonds), specialty (which typically invest in certain sectors of the economy), and index funds (which track a specific stock index). A mutual fund is managed so you don’t have to make any individual investment decisions, but there’s a cost involved.
All funds have a management expense ratio (MER), which includes the cost of having a portfolio manager make investment decisions as well as the marketing, legal, and administrative costs. This annual fee is usually between 1-3% and it’s unavoidable. You might also be charged a fee of as much as 6% for buying or selling a fund.
Some companies’ funds have either a front-end load (also called an initial sales charge) or a back-end load (also called a deferred sales charge). Mutual fund companies and a number of financial advisors typically offer load funds while banks offer no-load funds. Because of their high fees, many mutual funds can underperform the market. Index funds are a cheaper alternative. They have a lower MER, which are usually in the 0.33% to 0.75% range. If those costs are too high, there’s another option.
Exchange-traded funds (ETFs): An ETF combines the features of a mutual fund with that of a stock. Similar to a mutual fund, an ETF is an assortment of stocks or bonds. And like a stock, an ETF trades on a stock exchange. A mutual fund can only be bought or sold once each day while an ETF can be sold anytime the exchange is open. The biggest advantage of ETFs is the cost. The MER on ETFs are between 0.05% and 0.75%, but many are at the low end of the range. While there is a cost to buy or sell an ETF through a discount brokerage, some brokers may waive the charge. If you buy and hold an ETF for a long period of time, the overall cost will often be lower than a mutual fund or index fund.
GICs: A GIC is a bond-like investment offered by most financial institutions. It offers a guaranteed interest rate over a set period of time (usually one to five years). There are two types of GICs, redeemable and non-redeemable. A redeemable GIC has a low interest rate and can be cashed in at any time. A non-redeemable GIC has a higher interest rate and can typically only be cashed in when the term ends. When interest rates are low — like they are now — GICs less competitive investment over a long time horizon.
The bottom line
When choosing what types of investments to hold in an RESP, you should consider your time horizon. If your child is a newborn, you can be more aggressive and allocate a majority of your portfolio to equity funds or ETFs. As your child grows older, you can begin to allocate more money into fixed-income funds/ETFs or GICs.