Canadian investors have a number of tools available to build a substantial nest egg for retirement. One is the registered retirement savings plan (RRSP).
The RRSP is specifically designed to help Canadians put away savings that will eventually become a part of their income stream in the golden years. This is different from the TFSA, which can also serve that purpose, but it’s set up as a general savings product.
There are a number of reasons to consider using the RRSP before holding stocks in in a TFSA.
First, the government allows savers to reduce their annual income by the amount of their RRSP contributions. This is especially attractive for mid-career Canadians who have moved into the higher end of the tax bracket.
By deferring the tax today, Canadians have an opportunity to grow the contributions over time and then remove the funds in a tax-efficient way later in life.
For example, someone on Ontario’s Sunshine List is looking at a 2016 marginal tax rate of 43.41% on every dollar earned above $90,563.
If that person makes $101,000 this year and puts $10,000 in an RRSP, the effective cost is only $5,659 because $4,341 is headed to the taxman next spring if the contribution isn’t made. The $10,000 investment is then left to grow for a couple of decades and the person can often pull the funds out at a lower tax rate in retirement.
The RRSP is also a smart savings tool because the tax penalty for removing cash early tends to provide an incentive to leave the funds alone, unless the cash is required for an emergency.
Finally, the RRSP contribution allowances are quite generous. Canadians can contribute 18% of their earned income from the previous year up to a maximum amount. For 2016, the contribution limit is $25,370. Company-sponsored contributions reduce the limit, but many people still have significant room left over.
How can you build RRSP wealth?
Buying dividend-growth stocks and reinvesting the distributions in new shares sets off a powerful compounding effect that can turn a small initial investment into a large retirement fund over time.
Let’s take a look at Fortis Inc. (TSX:FTS) and Royal Bank of Canada (TSX:RY)(NYSE:RY) to see how the system works.
Fortis
Fortis is a power generation and natural gas distribution company with assets located in Canada, the United States, and the Caribbean.
The company has grown over the years through strategic acquisitions and organic growth, and the deals keep on coming. At the moment, Fortis is in the process of buying ITC Holdings Corp., a transmission company, for US$11.3 billion.
Fortis gets the majority of its revenue from regulated assets, which means the cash flow should be predictable and reliable. That’s great news for dividend investors and a big reason why the company has raised the dividend every year for more than four decades.
A $10,000 investment in Fortis 20 years ago would be worth $213,000 today with the dividends reinvested.
Royal Bank
Royal Bank is a very profitable company. In fact, the company generated 2015 earning of just under $10 billion. Yes, you read it right: $10 BILLION!
Royal Bank’s success is attributed to its balanced revenue stream. The company relies heavily on its retail operations but also has very strong wealth management, capital markets, and insurance groups.
The bank is also expanding its reach into the U.S. private and commercial banking space with the recent acquisition of California-based City National.
This stock has made some long-term shareholders quite rich. A $10,000 investment in Royal Bank 20 years ago would now be worth $231,000 with the dividends reinvested.
