New Year's Resolution: Save More!
Courtesy of Dynamic Mutual Funds, Posted 30 Dec 2014
Your New Years Resolution is a way to commit to improving your well-being, whether it's based on your health, fitness, habits, or, as we look at now, your finances. One method of improving your financial well-being might be to, simply, save more!
Ways to Save
Everyone should have some short-term savings or ‘emergency fund' that can be accessed quickly when needed. This could be for things such as unforeseen car repairs or to help manage expenses in case you lose your job. Most people agree that you should set aside at least three months of living expenses. Short-term savings should be readily accessible and, ideally, earning some interest in the meantime. You will need to consider the costs of getting money from other sources (such as your credit cards or other credit), as well as Employment Insurance and Short-Term Disability insurance, to determine how much of a financial cushion you need in your short-term savings. At the end of the day, you do not want to be tying up too much money in low interest-paying investments.
RRSPs are the most popular way for Canadians to set aside money for retirement. There are many specific features of RRSPs, and your Advisor can provide you with details. The most important to keep in mind, though, is that money you put into an RRSP will give you a tax deduction in the year that you make your investment and, while inside the plan, will grow tax sheltered – which means you won't pay tax on the money in your RRSP until you withdraw it in the future (presumably, when you retire).
Lump Sum versus Periodic RRSP Contributions
When you have an individual RRSP you will be responsible for making the contributions. Although you can make a lump-sum contribution at any time, there are definite advantages to establishing a regular contribution plan that automatically directs money from your bank account to your RRSP savings on a regular basis. These are usually referred to as Pre-Authorized Chequing–or PAC–plans and most financial institutions will allow regular contributions of as little as $25. By using a PAC plan you become used to the regular withdrawals from your account, which is probably easier in the long run than having to coming up with the money for a lump-sum contribution.
The Tax-Free Savings Account (TFSA) allows you to contribute up to $5,500 per year and invest it in a wide range of investments. Although there is no tax deduction allowed on the contributions (as in the case of an RRSP), the income earned in the account is tax-free and any withdrawals are tax-free. You can use the money in your TFSA to pay for such big ticket items as a car, home or travel. Money in it can be withdrawn tax-free at any time–and you can replace the money you take out of the TFSA the following year. As long as you are a Canadian resident 18 years of age or older with a SIN, you can open a TFSA.
The Long-Term Effects of Starting a Savings Plan
You've likely already heard of the power of compound interest or investment, and it is very true. Here is a simple example demonstrating the results you can achieve with a long-term savings plan. Please note that the following hypothetical calculation assume that the issuer of the investment doesn’t default and all cash flows are re-invested at the expected rate of return.
Investor age 21, investment term = 40 years
Amount to be invested = $25 per week
Expected rate of return = 3% annually
Type of Investment = RRSP (tax free growth)
Amount saved in 40 years = $100,500
In this example, our investor begins making $25 weekly contributions at age 21. After 40 years, she has saved $100,500, assuming a 3% annual rate of return. If she waits until age 35 to begin her savings plan, she will have to invest $50 per week to save the same amount of money by the same age.
So if you are thinking of making your New Year's Resolution one to improve your financial well-being, saving more just might be your answer, and a resolution you can stick to!