Sunday, February 11, 2007

Short-term pain for a long-term gain!

How do I save for the future? Here is my two cents on RRSPs.

For many Canadian (especially young Canadians), Registered Retirement Saving Plans (or RRSPs) something of a mystery; however, for the average lumberjack without a pension plan (and even for many with a company plan), RRSPs could help them find have that two scoops of raisins in retirement.

First some basic idea: RRSPs are financial investments (mainly stocks, bond, mutual funds) that you register with the government (most times through a banks, credit union or a broker). In exchange for promising to not withdrawal these investments until retirement, the government will kick you back the tax you paid on the income you invest (one notable exception is that first time home buyers can withdraw money from their RRSPs to purchase a home, as long as you pay it back later (see more here) ).

Here is the real kicker: what if you have no money to invest? Borrowing to invest in an RRSP is not a bad idea for some people. Why? Let's walk through an example: using the calculator . The assumptions given in the calculator are: you are at the 40% marginal tax rate (the percentage of tax on your last dollar earned in 2006), an investment return of expected to 8% (maybe high, but let's go with it), and you want to invest $1000 before MARCH 1st deadline. In addition, (here is really helpful part) it assumes you need to borrow to invest, and that you have to pay 6% interest on the money you borrow, and that you want to repay the money in 2 years or less. Lastly, you have to say when you want to retire: Our example assumes 10 year for now.
THEN: Click on "VIEW REPORT". Given our assumptions, you can pay back the money in 15 months if you use your tax return to pay down the loan, and make payments of $44.31 per month. The interest paid on your loan is $31.34, but after 10 years your RRSP has grown to: $2159. Neat! Now, what if I want to use different assumptions like, assume, I am 30 years from retirement?

Ok, new example, make the following changes: 35% marginal tax rate, 7% cost of borrowing, and 30 years to retirement. Leave everything else the same. How does that change things? We get less of a tax refund (because our tax rate is lower) and we pay about $10 more in interest charges (with higher interest costs), but now that we have 30 years to invest. So, in this example, we turn our $1000 into just over $10,000, assuming an 8% annual return.

Boy, that is fun eh? Give it a try and show your friends! The message: starting young is important, even for lumberjacks like us.

Final note: RRSPs are not for everyone. To know if they are right for you, I know that your financial institution will be happy to give you some professional advice (although I will take questions and do my best to answer them). With that being said, here is some helpful links: Government of Canada RRSP website , how about a self directed RRSP , some definitions to help you.


MadJenny said...

Gee you're smart sounding when you get all economicy. Not that you're not smart sounding the rest of the time, but you know - more smart.

Canadian Economist said...

Thanks madjenny. I know that economics does not mean adventure to most, but it sure is fun. I can play with the calculator for hours! :-)

MadJenny said...

Ok, question. I get money taken out of my account on the day of each pay deposit to go into an RRSP. Do you suggest this method? Or do you prefer lump sum payments? Also, which form of RRSP do you prefer - mutual funds? bonds? other stocks? GICs? etc?

False Prophet said...

You mean the March 1st deadline, right?

And regular deposits direct from your paycheque are the best way to go, MJ, since they follow two of the Wealthy Barber's rules: 1) pay yourself first and 2) use compound interest to your advantage. Although the Wealthy Barber isn't right about everything (back in the early 90s he was convinced mutual funds were a sure thing, then a lot of them did really poorly a couple of years later), he's right on these two counts.

If you have the money taken off your pay right away, before you worry about your bills, rent, gas, etc., you won't miss it. Also, because of our youth, any interest we earn today compounds--This chart shows that a $1000 RRSP invested for 40 years earns more money than a $10,000 RRSP invested at the same rate for 10 years.

Canadian Economist said...

Hi false prophet: thanks for the correction: March 1st (I will make that change). Nice link: very fun!

madjenny: I am going to do another post on this because it is sooo interesting!