The following excerpt is from Lesley Scorgie's book Rich by 40: A Young Couple's Guide to Building Net Worth . Ms. Scorgie has been writing and speaking about personal finance for nearly a decade, and has appeared on many TV shows including The Oprah Winfrey Show and MTV Live.
Key #1: Get Started-The Longer You Wait, the More You Lose Out
Zach, thirty, has been investing in stocks since he graduated from university. His parents, on the other hand, are in their mid-fifties and just started saving for retirement. Zach worries about his parents' financial security. No matter how diligently they save over the next ten years, it's going to be tough to save enough money for their fast-approaching retirement.
In Chapter 2, I introduced the concept of compound interest and reinvested returns. The way it works isn't magic at all: you earn interest and returns on your initial investment (the principal), which is then reinvested, allowing you to earn interest and returns on it, as well. So now you're earning interest and returns on top of your existing interest and returns. Then you start earning greater interest and returns because they're reinvested on top of the principal. On and on it goes, growing your money exponentially over time. The more time you have to allow compound interest and reinvested returns to compound itself, the more money you'll earn.
When you wait to invest, you lose time, which affects your exponential growth potential. Let's say you start investing $150 a month at the age of twenty and earn a 9 per cent annualized return on your portfolio. By the time you retire at sixty-five, you'd have approximately $1 million in your portfolio. Not a bad sum of money considering you had to contribute only $81,000 of your own money ($150 per month X 12 months a year X 45 years).
Now let's say you wait to start investing until you're thirty. If you invest that same $150 a month and earn a 9 per cent annualized return on your portfolio, at sixty-five, you'd have approximately $425,000 in your portfolio; significantly less than if you had started investing at age twenty. In this instance, you would have contributed $63,000 of your own money ($150 per month X 12 months X 35 years).
If you wait until age forty, using the same scenario, you'd have less than $170,000 in your portfolio, having contributed $45,000 of your own money ($150 per month X 12 months X 25 years). The size of this investment portfolio is significantly smaller than both examples above.
What's so shocking about this comparison is that if you wanted to have $1 million at retirement, and you started saving at age thirty, you'd need to save $350 per month until age sixty-five, earning a 9 per cent annualized return. That's $200 more each month than if you'd started saving $150 per month at age twenty. In total, you'd have to contribute $147,000 of your own money to achieve the same result. Now if you wait until you're forty to start, you'd need to invest $900 per month until sixty-five to have that same $1 million, earning a 9 per cent annualized return on the portfolio. That's $750 more each month than if you'd started saving at age twenty. In total, you'd invest $270,000 of your own money to achieve the same result.
The earlier you start investing, the more you will benefit from the power of compound interest and reinvested returns. And you'll end up shelling out a lot less of your own money. Don't get discouraged if you're starting to invest a little later in life. You can still catch up by contributing more money into your savings and investment plans. You're likely earning more money as you'll be a little further into your career so you can afford to allocate more into your plan. Visit www.getsmarteraboutmoney.ca to calculate your investment scenario using their calculators.
Key #2: Use the Right Plans
Tasha jokes with her co-workers that her retirement savings plan is her $10 weekly lucky lotto ticket. She doesn't know much about money, but she still contributes a small amount to a TFSA and RRSP each month. For her, investing isn't a top priority. She'd rather focus on planning her next vacation with her boyfriend.
There are many types of investment plans, but several of them, in particular, are really important. The Registered Retirement Savings Plan (RRSP) and company pension plans have tax advantages and are specifically geared toward retirement savings. The Tax-Free Savings Account (TFSA) also has a tax advantage and can be used for both short and long-term savings. Non-registered investment plans have fewer tax advantages, but they can be used for just about anything. Last, the Registered Education Savings Plan (RESP) is loaded with tax and contribution advantages designed specifically to help you save money for a child's education.
The beauty with these plans is that once they're set up, they're fairly low maintenance and you benefit from their unique advantages, such as deferred taxes through an RRSP, immediately.
Registered Retirement Savings Plans
According to a study conducted in 2008 by BMO Bank of Montreal, less than half of Canadians make a Registered Retirement Savings Plan contribution each year. If you're over eighteen and employed or self-employed, you should contribute to an RRSP. In the majority of cases, the associated tax advantages make this the best tool for long-term retirement savings available to Canadians. Unemployment can get in the way of contributing to an RRSP, but once you're working again, pick up where you left off and contribute regularly to your plan.
RRSPs are designed specifically to make saving for retirement a lot easier than trying to do it outside this plan. Annually, you're allowed to contribute up to 18 per cent of your income into the plan and you receive a tax deduction in exchange for your contribution. Contributions must be made by March 1 for a tax deduction for the previous year. So if your contribution limit for 2010 was $10,000, you'd have up to March 1, 2011, to make your contributions for the 2010 tax year.
Funds within the RRSP grow tax-free until withdrawal, at which time you pay taxes at the highest marginal tax rate. Though the tax rate is based on the highest marginal rate, remember, you'll be retired and not making nearly as much money as when you were working.
The major benefit is that you defer paying taxes on that money until your retirement, which is very useful when you're starting out in your career, purchasing your first home, growing your family, and travelling. Tax deferral allows you to maximize your savings opportunities because less of your income is going to taxes.
You can select almost any type of investment to put in your RRSP-stocks, bonds, mutual funds-and get a valuable tax advantage that typically allows you to save way more money than if you invest outside a registered plan.
As I mentioned, you can contribute 18 per cent of your earned income for the preceding year, up to a certain maximum. If you contribute more, over $2,000 beyond your limit, you're penalized by Canada Revenue Agency (CRA) at a 1 per cent tax per month, so stick to the limits. The maximum limits are indexed for inflation each year, so check Statistics Canada for annual updates or Canada Revenue Agency to access your personal limit.
So, let's say Pedro makes $65,000 a year. His annual maximum contribution limit would be 18 per cent of $65,000: $11,700. If Emily makes $150,000, her 2010 limit is $22,000, which is less than 18 per cent of her income, but she caps out at the RRSP maximum contribution limit due to her high income.
If you don't use the full amount of contribution room within your RRSP, you can carry forward the unused amount from prior years indefinitely. This is a fabulous RRSP feature because if you can't afford to maximize your contributions, you can try the next year or the year after that or the year after that (you get the point).
How Can I Make the Most of My RRSP?
To get the most value from your RRSP, maximize your allowable yearly contributions. You get a greater tax advantage plus you'll have a larger portfolio. Maxing out your RRSP may appear daunting, but the following strategy will make the process much easier without cramping your cash flow too much. I call it "Max Out the Easy Way."
1. Start. Set up regular RRSP paycheque contributions. For example, if you start contributing $50 every two weeks, you'll make twenty-six instalments of $50, bringing your annual total contribution to $1,300.
2. Take any free company money: Sign up for your company's pension plan or RRSP savings program. Employers often match your contribution up to a certain amount, which is free money. With a company pension plan, they take your contribution out of your pre-tax earnings, whereas if you invest independently through a financial institution, you use after-tax dollars but you get a tax credit, which allows you to save more (see the pension plan section below for more information).
3. Increase: Increase your contributions each year. For example, turn that $50 biweekly contribution into a $100 biweekly contribution, bringing your annual total to $2,600. Increase it again the following year from $100 to $150 biweekly, bringing your total contribution to $3,900. If you're fortunate enough to have a salary increase, allocate part of your incremental income to your RRSP.
4. Borrow to maximize: Approximately three to five years after starting your RRSP, borrow money to maximize your contribution. So if your limit is $12,000 and, between your company plan and personal RRSP savings, you have saved $6,000 yourself, borrow the remaining $6,000 to maximize your contribution. Typically RRSP loans have relatively inexpensive interest rates and very flexible repayment plans. An alternative to an RRSP loan is to borrow using a low-interest line of credit. Borrow at the lowest possible interest rate, so shop around.
You may be wondering, "Why go into debt to invest in my RRSP?" Two reasons: First, the more you contribute, the greater the tax deductions when you file your tax return. Therefore, you save taxes and can sometimes earn a large tax return, which can then be used to pay down your loan. If you're not going to get a return, ensure you can afford the monthly payments on the loan. Ideally, you'll want to pay the RRSP loan off within one year. Second, money grows exponentially. More money grows faster than less money through the power of compound interest and reinvested returns. So, the more you save, the more you'll potentially earn.
5. Ease your way out of borrowing: While you're borrowing to maximize your contribution, remember to continue increasing your annual investment. Within a few years, you'll be maximizing your RRSPs annually on your own without the help of a loan.
The 411 on RRSP Loans
When does it make sense to take out an RRSP loan? This type of loan is designed for people without available savings who want to make an RRSP contribution before March 1, so that its taxable benefit counts for the previous tax year. For example, to get a taxable benefit for contribution year 2010, you would have to make an RRSP contribution by March 1, 2011.
The RRSP loan tends to have a reasonable interest rate hovering near prime, and should be paid off within a year or two. It makes sense to take out the RRSP loan in a couple of circumstances: first, when the taxable benefit you receive from your RRSP contribution is greater than the amount of interest you'll pay on the loan. To help figure out if it's worth it, see an adviser or ask an accountant. Second, the more you contribute, the more you'll earn through compound interest and reinvested returns. Let's say you decide not to borrow that extra $5,000 to maximize your RRSP at age thirty. That $5,000 compounded at 8.5 per cent for twenty-five years adds up to just less than $40,000 before tax when you're fifty-five. So you miss out on tens of thousands of dollars in compound interest and reinvested returns. And the $5,000 RRSP loan you could have taken out wouldn't have cost you anywhere near that amount.
Keep in mind that the credit applications for an RRSP loan are subject to meeting the financial institution's lending criteria. Using borrowed money to finance the purchase of investments within your RRSP is riskier than using cash. So make sure you're comfortable with this risk. If you borrow to invest in your RRSP, negotiate for the best interest rate, read the fine print on the contract, and ensure you can make the monthly payments.
Registered Pension Plans (RPPS) are established by employers for employees or unions to assist them with their retirement savings. According to Statistics Canada, in 2006, 38.1 per cent of paid workers had an employer-sponsored registered pension plan. This means more than 60 per cent of paid Canadian workers either didn't have access to one or simply weren't participating. Some companies have an opt-out clause where the employee can choose whether to contribute to the RPP; other companies have mandatory participation. If you're fortunate enough to have access to a plan, don't opt out. With most company-sponsored pension plans, the employer kicks in free money or free benefits. Don't turn your back on free money! You can usually sign up within the first year of your employment.
There are two main types of RPPS: defined contribution plans and defined benefit plans. The most commonly issued plan in Canada is the defined contribution plan. With this plan, the employer and you pay a predetermined amount of money into your pension, but you get to choose, from a variety of investment options, where it gets allocated. Similar to an investment plan, your pension benefits are whatever you've accumulated in contributions and investment returns.
Because you make the investment choices for the plan, you are 100 per cent responsible for the profits or losses associated with your decisions. Your employer is not responsible for the pension plan's performance. Be aware that your employer and the pension-plan managers (or committee members) often have a say over the package of investments. So if you made a bad investment choice from the available selection, your employer isn't responsible for the outcome of that decision-likely a decreased investment value.
Does the defined contribution plan sound a bit risky? There's really no need to worry. You'll learn more about what investments to choose in the next chapter. In fact, being in control of your own pension plan can be great because you determine what goes into it.
What's great about the defined contribution plan is most employers will match the employees' contributions up to a certain proportion. If you contribute 4 per cent of your salary, and your employer matches it 100 per cent, it will add an additional 4 per cent. Or you might contribute 6 per cent and your employer contributes 3 per cent matching 50 per cent of what you contribute. Whatever the specific matching program is, it makes sense to maximize your portion of the contributions into the plan for two reasons: you contribute with pre-tax dollars and you get free money from your employer.
Here's an example of how a defined contribution plan can work. Let's say Alan makes $40,000 a year as a junior sales representative for a pharmaceutical firm. He doesn't use his company's defined contribution pension plan. Instead, Alan invests 10 per cent of his gross annual income, $4,000, with after-tax dollars, through his financial institution. Since the average Canadian pays approximately 30 per cent of his or her income in tax and deductions, Alan's tax and other deductions from his gross pay amount to $12,000, which reduces his leftover income to $28,000. Out of that remaining $28,000, he invests $4,000, which means he has only $24,000 left to spend each year on things like rent, groceries, a cell phone, vacation, and other things. Saving $4,000 annually means he'll have to tuck away $333 per month.
Jake, on the other hand, works in the same department, makes $40,000 per year, but uses the company plan at work. If Jake saves 10 per cent of his gross annual income (so $4,000) in pre-tax dollars, he ends up paying 30 per cent taxes (also deductions) on $36,000, which amounts to $10,800. That's $1,200 less in tax than what Alan paid, leaving Jake with $25,200.
In both scenarios, Alan and Jake save $4,000 annually; however, Jake keeps $25,200, and Alan keeps $24,000. For Jake, that means he'll have an extra $1,200 per year, or $100 per month, to spend.
If that doesn't convince you to sign up for your company's plan, maybe this will. Let's say Jake and Alan's employer has committed to matching 50 per cent of employees' contributions if they use the company's pension plan. That would mean Jake would have saved $4,000, and his employer would have added an additional $2,000 to his plan for a total of $6,000. In essence, this is like getting a $2,000 raise. Alan, who invests outside the plan, will not reap the same benefits. See the table on pages 186 to 187.
When you and your employer contribute to a defined contribution (or a defined benefit) plan, your contribution does eat up a part of your RRSP contribution limit. Nevertheless, sign up and maximize the use of your company's plan. Remember that more money grows faster than less money-and take any opportunity for free money!
A minority of Canadians continue to enjoy a defined benefit plan. With this plan, you receive a defined or pre-set payout each month once retirement hits. In this case, the employer shoulders all the risk associated with managing and funding the plan. So even if the markets perform poorly, making the plan more costly to provide, the employer will still pay the same amount of pension promised to the employee.
From an employee's perspective, this plan is a worry-free solution to retirement planning. From an employer's perspective, this plan is expensive and has a great deal of risk associated with it. Since early in 2000, underfunding of defined benefit plans has significantly increased. This has been a large contributor to many employers opting for the defined contribution plan, or a hybrid between the two, going forward.
The actual benefit received through a defined benefit plan is based on a formula that is applied to your income nearing the end of your employment, when you typically earn the most money. The details of the formula are located in the fine print of the plan. In certain cases the defined benefit plan is 100 per cent employer funded, while in others, it is the joint responsibility of the employee and employer to fund.
The only thing pensioners have to worry about with the defined benefit plan is whether their employer goes bankrupt. But, even if this happens, there is a great deal of legal protection for pension assets. In many situations, the worst-case scenario is your pension would be reduced, but not eliminated.
In either the defined-contribution or defined-benefit scenarios, if you leave your job, make arrangements to transfer your pension to your new employer and/or a financial adviser.
What Should You Do?
It's critical that you take a serious interest in your company pension plan as it can be worth hundreds of thousands of dollars by the time you hit retirement. Even if you plan on leaving your job and transferring your pension, it's still a good idea to know how it works and how it's being managed.
The key with RRSPs and RPPS is to use them for long-term retirement savings. They are not intended for short-term savings.
If you're self-employed, you should be even more concerned about your pension benefits considering you are your own employer. As a self-employed person, you can set up an Individual Pension Plan (IPP), which has tremendous tax advantages and retirement solutions. IPPs are a bit tricky to understand and expensive to set up, therefore you should see an adviser for help. Both the costs of setting up and contributing to the ipp are tax-deductible expenses for the business. Allowable contributions are often significantly higher than maximum RRSP contribution limits. You can also fund the ipp back for prior years, meaning you can put more money in upfront. You can make both regular and voluntary contributions. Contributions grow tax deferred until withdrawal. Because you can put more money into the plan than in an RRSP, there's a greater opportunity to grow your money through tax savings, compound interest, and reinvested returns. Additionally, the funds within the plan are creditor protected as they reside within your corporation.
Tax-Free Savings Account
In 2009, the federal government introduced the tax-free savings account, which allows Canadians eighteen years of age and older to save and grow their money tax free. Each year you can contribute $5,000. This amount is indexed to inflation.
Though your contributions aren't eligible for a tax deduction, your earnings within the plan aren't taxed. So, basically your money grows tax-free, even when it is withdrawn. With an RRSP you're fully taxed at your marginal tax rate when funds are withdrawn.
As with an RRSP, RPP, or other non-registered plans, you can put a variety of investments within the TFSA, from GICs to stocks to mutual funds and the like. Your contribution room is also carried forward indefinitely, so if you can't contribute one year, you can make up for it the next year.
When you withdraw the funds, which you can do without penalty at any time, you don't pay tax on capital gains, dividends, trust distributions, or interest earned. On the flip side of this, capital losses within the plan are not tax deductible and dividends aren't eligible for the dividend tax credit. Another major benefit of the TFSA is if you withdraw money, you can re-contribute your funds one year after withdrawal. This means you, in essence, get your contribution room back. So, if you grew your TFSA to $30,000, you could withdraw it, not pay tax on its growth and have an additional $30,000 in contribution room that you could put back into the plan in the future.
Unlike the RRSP and RPP, the TFSA can be used for either short or long-term saving, so a TFSA can be a great tool to save for down payments, vacations, or weddings. If you invest for the long term, you'll reap the benefits of long-term growth and additional compound interest and reinvested returns.
Whatever your goals, the best way to utilize a TFSA is to maximize the allowable yearly contribution. This strategy, like any other type of investment plan, means there'll be more opportunity to earn through compound interest and reinvested returns.
Non-Registered Investment Plans
Non-registered investment plans have fewer tax advantages. Returns generated within a non-registered plan do benefit from a dividend tax credit and a favourable capital gains tax rate (laws and regulations on taxes can change so it's important you research and review your current tax situation with a tax accountant). They are, in many cases, accounts for independent investments that don't fall within an RRSP, RPP, or TFSA. Non-registered plans come in very handy when you don't want to contribute to an RRSP or TFSA, maybe because you've maxed out your contribution limits. Prior to 2009, the TFSA wasn't available so many people saved in non-registered plans as well as in RRSPs. A non-registered plan also can be used to house non-eligible RRSP investments (this would be disclosed on the investment itself or the program it's associated with).
Sometimes employers have independent non-registered savings programs such as profit sharing or a share purchase plan that employees can use in addition to their rpp; if the employer contributes to it as well, it becomes a taxable benefit and you'll have to pay tax on the money contributed by your employer. Still, it's almost free money!
The RRSP versus the TFSA versus Non-Registered Plans
The primary difference between RRSPs (and RPPS), TFSAs, and non-registered investment plans is in the ways you're taxed. The following example illustrates the point.
If you invest $5,000 in a mutual or index fund that generates returns each year, in each of the plans, and allow for all returns to be reinvested and compound at 8.5 per cent annually for twenty-five years, your net proceeds from the RRSP is greatest, followed by the tfsa. But you don't earn nearly as much with a non-registered plan primarily because you're taxed yearly on those earnings. (This example uses an investment income tax rate of 28 per cent. Laws and regulations on taxes can change so it's important you research and review your current tax situation with a tax accountant.)
Wondering what's best for you? Based on this mutual/index fund example, the RRSP (and rpp) allows you to get a head start on earning more potential returns because the sum invested is larger. The TFSA earns less return upfront, but pays less tax in the future. The non-registered plan ensures you pay taxes throughout the course of the plan, which really eats into the amount of money you're able to earn and build. There are still benefits to investing in a non-registered plan, but the tax incentives in the TFSA and RRSP are generally more favourable.
With this example, there's one more thing to be aware of: you may not know the tax rate at the time of withdrawal compared to when you contributed.
Since your RRSP limit (18 per cent of your income) will likely be much higher than that of the tfsa ($5,000 and indexed into the future), you'll be able to save the most in an RRSP each year, which earns you more in compound interest and reinvested returns. Additionally, your tax rate upon withdrawal could be lower as you'll be retired.
Your first priority should be to maximize your RRSP contribution room. Second, maximize your tfsa room. Third, contribute any additional savings into a non-registered plan. If you can't max your RRSP limit and still want to contribute to the TFSA, use a hybrid approach-I'd recommend two-thirds RRSP and one-third TFSA. A hybrid approach works well because your tax deduction in the RRSP is greater because you're contributing more plus you get to grow your money tax-free in the tfsa. It's like having the best of both worlds.
From Rich by 40 Copyright © 2010 by Lesley Scorgie. Published by arrangement with Key Porter Books.