An Angus Reid Institute poll this week suggested that inflation is forcing Canadians to take drastic measures to make ends meet.
As our dollars erode, he found that most of us are cutting back on spending and delaying major purchases. It also revealed that 19% of respondents are deferring or not investing in their Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Account (TFSA).
In many cases, cash-strapped households have no alternative. But those who are able to choose to reduce their RRSP and TFSA contributions could miss out on the anti-inflationary power of compound interest.
How compounding works
The actual mathematical formula for calculating compound interest is complex and there are plenty of calculators online to do it for you.
In short, it is interest on a principal amount plus interest on interest that accumulates over time. The more frequently it is compounded (monthly or annually, for example), the higher the compound interest it generates.
One way to illustrate the power of compounding is to follow what is known as “the rule of 72”. You can determine how long it will take for the principal amount to double by dividing the interest rate by 72.
At a rate of ten percent, it will double in 7.2 years. At four percent, it will double in 18 years.
Composition of your TFSA investments
To simplify things, let’s assume that your TFSA investments are earning a compound annual rate of return of 5% after inflation. Currently, inflation is in the 10 digits but will hopefully average lower over the next 30 years.
Let’s also assume that the current value of the investments in your TFSA is $50,000 and, despite the added burden of inflation right now, you can manage to raise a contribution of $10,000 each year.
Using one of the many debt calculators available online: After 30 years, your $350,000 in total contributions will have generated $563,705 in compound interest, bringing your total TFSA savings to $913,705.
An added benefit of having all that money in your TFSA is that you don’t have to pay tax on compound returns and they can be withdrawn at any time.
Supercharged Compounding in RRSP
Compounding often produces higher returns in an RRSP because savings amounts are generally higher. However, unlike a TFSA, contributions and returns are fully taxed when withdrawn.
On the positive side, you can increase the compounding power of an RRSP by reinvesting the tax refund generated by the initial contribution. The amount of the refund is based on the tax that would have been imposed if the contribution had never been made. If your top marginal tax rate is 40%, for example, your refund would be 40% of the contribution amount.
Reinvesting the refund would generate another 40% refund of the refund amount, which would generate a 40% refund on that amount…and so on.
All the while, compounded contribution amounts will accumulate in investments over time.
Compounding cuts in both directions
Albert Einstein once said, “He who understands composition, wins it; whoever doesn’t, pays for it.
Compounding is a double-edged sword that cuts especially hard for those deeply in debt. The same basic formula applies to the money you owe – and in many cases the rates are much higher.
It is rare to find a non-mortgage consumer loan with an interest rate below 10%. Credit cards often come with interest rates above 20%.
As rates rise, more of the regular debt payments go to interest, and there’s not much left to nibble on the principal.
In many cases, paying off debt is the best investment you can make. Think of it as generating a guaranteed annual return equal to the rate you are charged – tax free.
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