Other than winning the lottery or inheriting a fortune, saving is generally the best option for making big plans for the future come true or enjoying a comfortable retirement. Reaching that goal, however, might not be a matter of just saving more. What about saving differently?
Here are four practical examples.
1. Start early, or how to get more from less
Time just might be the most important factor in a savings strategy, especially in a tax-deferred plan (such as an RRSP) or a tax-free savings account (TFSA). Time is what can unleash the full potential of compounding, where each year’s returns are calculated not only on the capital, but also on the returns from previous years. To get an idea of how it works, take a look at the graph below. In the two cases illustrated, you invest the same amount each year. But in the first case, you make these investments from age 25 to age 40, i.e., for 15 years. In the second case, you start investing at age 35 and continue for 30 years. The numbers speak for themselves.
Invest early in the year
This may seem insignificant, but the same logic applies to the time of year that contributions are made. The difference between a contribution invested in January and one invested in December could well be a full year of compound returns. To continue with the assumptions from the previous example, an annual contribution of $10,000 could result in additional capital of over $75,000 after 35 years if made at the start of the year. And if this doesn’t sound like much, keep in mind that it was obtained without investing a penny extra.
Notwithstanding the first two principles stated above, it might be easier to make regular investments of a smaller amount rather than waiting until you’ve saved up a larger sum. And in fact, the figures tend to show that this could be an excellent strategy for two reasons. First, given the same annual total, regular savings can start producing compound returns earlier in the year, compared to investing the whole lump sum at the end of the year. For example, using the same return assumptions as above, a contribution of $833 per month could provide more capital after 35 years than an annual lump-sum contribution of $10,000 – to the tune of about $72,500. Once again, this would be a “performance bonus” that wouldn’t require any additional investment.
The second reason that this regular investment strategy could be advantageous is that you would be buying units at various points in the market cycle, thus levelling out the average acquisition price, a principle known as “dollar-cost averaging.”
Invest with taxes in mind
Finally, it is possible to optimize returns by favouring the types of accounts or investments that offer tax-efficient features. For example, registered education savings plans (RESP), registered retirement savings plans (RRSP) and tax-free savings accounts (TFSA) all allow capital to grow over many years in a tax-sheltered environment.
Furthermore, RRSPs might also allow individuals to make contributions during a life stage when their marginal tax rate is highest, thereby maximizing the tax savings, and then to make withdrawals at a time – during retirement – when their tax rate may be lower.
Lastly, if you invest in a taxable account, keep in mind that investment income in the form of capital gains or dividends is generally taxed at a lower rate than interest income.
That said, the principles and calculations presented here are obviously based on the rule of “all else being equal,” particularly when it comes to the amounts invested and the annual average returns. To see how they might apply in real life, don’t hesitate to speak to your advisor.
The following sources were used to prepare this article:
Desjardins, “The advantages of making early RRSP contributions”; “How tax affects your investment income”
Desjardins Online Brokerage, “Contribute Early, Contribute Your Maximum.”
Get Smarter About Money, “RRSP Savings.”
Retire Happy, “2021 RRSP guide: RRSP deadlines, contribution limits, and more.”
SFL, “Exploring compound returns.”
Times Colonist, “Why you should contribute to your TFSA early.”
Vanguard, “When should you start saving for retirement?.”
Wes Moss, “A Chart Every 25-Year-Old Needs To See Today.”