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Fredericton Daily Gleaner ~ Capital Appreciation ~ Compound Interest ~ July 24, 2006 - 26 Jul 2006 by TaxHelp

As we were driving home from visiting our daughter Jennifer in Cape Breton the other day, a song came on the radio by Paul Revere and the Raiders. Who says time travel hasn’t been invented yet? Did you ever notice that when reminded of something from years long ago, you can conjure up in your memories the feelings as if they were a few months ago? With a little effort, I can remember the excitement of waking up early one spring Saturday morning and pedaling my bike down to our Canadian Tire to pick up a brand new St. Mary’s baseball bat – less than a Louisville Slugger and made in Canada to boot – and then stopping on the way home for a drink of water from someone’s garden hose and tasting the brass of the well used nozzle. Just like that – 40 years in the blink of an eye!

Why the trip down memory lane? As they say, youth is wasted on the young. They also say time flies.

Ever heard the phrase “the magic of compound interest”? Basically, it refers to the growth of capital and how it’s influenced by rate of return and time. Of course, when we’re young investing is probably for most of us the last thing on our minds. However, the amount of money we save can end up being heavily influenced by the time horizon we have.

The first thing you should understand is the “Rule of 72”. Basically, this little formula tells you how long it takes for money to double. You take the interest rate you earn and divide it into 72. If you earn 10 per cent, money doubles in about 7.2 years. If you earn 20 per cent money doubles in about three and a half years. If you earn 5 per cent money doubles about every 14 years. So simply put, if you have $10,000 today and can earn 15 per cent, in about five years you have $20,000. In ten years that sum has grown to about $40,000 and in about 15 years it’s about $80,000. Put another way, someone 40 who puts $10,000 away and leaves it there and can earn 15 per cent will have about $320,000 at 65, using this little napkin math formula.

Now 15 per cent seems extravagantly high as a rate of return in this environment, but there are some vehicles out there that do generate those types of returns. For instance, Standard Life has a Canadian dividend fund that has earned over 16 per cent since it’s inception over ten years ago. But for comparative purposes let’s look at 5 and 10 per cent returns and the importance of earning as much as possible. If we take someone 35 today, who plans on retiring in 30 years, and have him put $200 a month into a Registered Retirement Savings Plan (RRSP) at 5 per cent, when he retires he’ll have over $160,000 which is a tidy little sum. But if the same individual could earn 10 per cent, the estate grows to over $400,000. In other words, with the same effort the second scenario generates a quarter of a million dollars more.

RRSPs are the best tax deferral device available to the average Canadian. Sometimes I hear that they’re no good because of the big tax bill at the end. But let’s really look at the numbers. Let’s use these assumptions – the taxpayer is in the lowest tax bracket, which has a combined federal – provincial rate of about 25.5 per cent and can make a $200 a month saving deposit and can earn 10 per cent over the 30 years until retirement. If he does not buy an RRSP, he must pay tax on the interest as it is earned. This means that his savings after tax will grow to about $255,000. However, if he buys an RRSP, he gets an immediate tax deduction giving him an additional tax refund of about $600. Plus, his savings grow tax deferred. In other words, he doesn’t have to pay tax on the growth while it’s in the RRSP. So what does the same investment do within an RRSP? $416,169! And that’s not the end of the story! If he takes the $600 refund and invests it at 10 per cent in some mutual fund as an example, it grows to over $66,000. The bottom line is with the RRSP and refund savings at retirement our friend is looking at over $480,000. If he withdraws the funds systematically from the RRSP the tax bill could be as low as $106,000. So after tax in the first case, the guy has $255,000 while the second guy has more than $375,000 – all from a simple $200 a month investment.

Anyway, the keys are rate of return and time. And I’ll leave you with this thought – if the second guy started at age 20 his retirement nest egg would be north of $2 million bucks. Makes for an interesting kitchen table discussion with the kids.

Roger Haineault is with Help 4 Taxes. He can be reached by email at roger@help4taxes.ca or by calling 1-888-450-1212. His column appears Monday.