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(Rosemarie Gearhart/iStockphoto)
(Rosemarie Gearhart/iStockphoto)

TAX MATTERS

Taxes: Why you should start investing while you're still young Add to ...

Tim Cestnick is president of WaterStreet Family Offices, and author of several tax and personal finance books. tcestnick@waterstreet.ca

There’s nothing like an education about money while you’re still young. Consider the story of Lael Desmond, a graduate student from Indianapolis who set up a discount brokerage account with Ameritrade several years ago. He eventually filed a complaint against Ameritrade to recover the $40,000 he lost when investing in high-risk Internet stocks using money borrowed on margin. Mr. Desmond’s lawyer acknowledged that his client had read and signed a disclaimer that explained the risks, but he said that’s beside the point. “Yes, he agreed to it. But they shouldn’t have let him,” he said.

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I’m a firm believer in educating kids at a young age about investing – and starting them investing early in life. Aside from helping young people make wise decisions about their investments, starting young can lead to a much larger portfolio down the road. Time is an investor’s greatest ally. As we head into registered retirement savings plan (RRSP) season, encourage your adult children to contribute to their RRSPs. Here are some stories about the value of starting young.

Laurel and Hardy

Laurel and Hardy are friends, both of them 30 years old. Laurel has wanted to get a head start in saving for retirement and has decided to invest $5,000 each year, starting this year. Suppose he invests $5,000 annually in his RRSP or TFSA for 10 years (to age 40). His total investment will be $50,000 ($5,000 per year for 10 years). Suppose he then stops contributing to his plan and simply watches his portfolio grow until he reaches age 65. If he earns 7 per cent on his money annually, he’ll have $374,940 in his portfolio at age 65.

Now, consider Hardy. Like many, he’s a procrastinator, and let’s assume he waits eight years, until age 38, before he starts saving for retirement. At that time, he starts saving $5,000 per year, every year, until he’s age 65. So, Hardy will have invested $135,000 in total ($5,000 per year for 27 years). Assume he earns the same 7 per cent return on his portfolio and he also invests inside his RRSP or TFSA. At age 65, Hardy’s portfolio will be worth $372,420.

You’ll notice that Laurel and Hardy each have about the same-sized portfolio at age 65, but Laurel had invested just $50,000 while Hardy invested $135,000 to achieve the same results. The fact that Laurel started eight years earlier makes a huge difference in how much he needs to invest to achieve his retirement goals. By the way, if Hardy were to wait just two more years to start saving at age 40, he’d end up with just $316,245 – a full $56,175, or 15-per-cent less than what he’d have by starting at age 38.

Laverne and Shirley

Let’s take a look at this from another perspective. Laverne and Shirley are friends, both 35 years old. They have each decided that they’d like to accumulate $1-million by age 65, 30 years from now. Laverne is pretty disciplined about her savings and has decided to start right away, investing in her RRSP. She’ll have to set aside $10,600 annually to reach her $1-million target, assuming she can earn 7 per cent on her portfolio over that time.

What about Shirley? She has decided to wait five years to start saving at age 40. If Shirley hopes to accumulate the same $1-million by age 65 she’ll need to invest $15,850 annually at the same 7 per cent return. That is, she’ll need to invest 50-per-cent more annually than Laverne to accomplish the same goal, since she’s starting five years later.

As an aside, what if these two women want instead to save $2-million each by age 65? Laverne would have to invest $21,175 annually starting today (at the same 7-per-cent return), and Shirley would have to invest $31,650 annually starting in five years.

Shirley could also run into another problem: She might not have enough RRSP contribution room to allow herself to invest that much in an RRSP annually. The amount she needs to set aside could exceed her RRSP contribution limits. RRSPs are best designed for use over many years, not for “hyper-savings” in the last years leading up to retirement.

How much to save

Be aware that $1-million will provide a pretax annual income of $60,000 for 28 years (assuming a 4-per-cent annual return in retirement). To accumulate this $1-million, it will take just over $10,000 set aside annually, invested at 7 per cent, for a period of 30 years, or $5,000 annually for 40 years.

 

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