One of the more useful tools I use as an advisor is what is often referred to as the rule of 72. While not completely accurate, the rule of 72 provides a simple way of estimating how much your investment will be worth at a given rate of return. Here is how it works:
Divide 72 by the rate you assume your investment will earn. The result gives a close approximation of the number of years it will take for your investment to double.
Let’s say you invest $100,000 with an assumed rate of return of 7.2 per cent per year. How many years will it take for that investment to double? To find out, divide 72 by 7.2 — which equals 10. Therefore, in about 10 years your $100,000 investment (at 7.2 per cent per year) would be worth $200,000. And in 20 years, it will have doubled again to $400,000. Using my electronic calculator I tested the result and found that indeed the investment would reach double its original value shortly after the end of the tenth year, and will have quadrupled by around year 20.
This may seem surprising. At 7.2 per cent per year for 10 years, some might expect the investment to grow by 72 per cent (7.2 per cent times 10). But instead it grows by about 100 per cent.
Why the discrepancy? We refer to it as the power of compounding, and it works like this: If you invest your money and leave it alone, not only do you earn a return on the original investment, you earn a return on the annual gains that accrue as well.
It’s another reason why compound interest and RRSPs go hand-in-hand. Typically when you make money on your investments you are required to pay income tax. Depending on the nature of the investment gains, at least some tax may have to be paid annually. And unless you can afford to pay these taxes from other income, you may find yourself having to cash in some of the investment.
However, by putting your investments into an RRSP, not only do you get a tax deduction on your original investment (within limits), but you also benefit from tax-free compounding.
In recent years the wisdom of investing in RRSP’s has been questioned by many. Sure the RRSP provides a tax deduction, but when the money is withdrawn during retirement you have to pay the taxes then.
Most RRSP investor understand this, but also understand their taxable income will likely be lower (and taxed at a lower rate) when the money is withdrawn during retirement. What is often overlooked is the significant advantage of tax-free growth — the fact that money which would otherwise need to be paid in taxes on investment gains is allowed to remain in an RRSP and compound accordingly. In other words you are earning a return on money that you would not otherwise have.
Now we also have the Tax-Free Savings Account, which also allows for tax-free compounding.
Which is better? That depends, and usually both are advantageous. Feel free to contact our office for more information.
Jim Grant, CFP (Certified Financial Planner) is an Investment Funds Advisor with Raymond James Ltd (RJL). The views of the author do not necessarily reflect those of RJL. This article is for information only. Raymond James Ltd. is a member of CIPF. For more information feel free to call Jim at 752-8184, or firstname.lastname@example.org. and/or visit www.raymondjames.ca.