Registered Retirement Savings Plans, more commonly referred to as an RRSPs, are one of your greatest tools for building long-term wealth.
Whether you’re investing in growth stocks like Canada Goose Holdings Inc (TSX:GOOS)(NYSE:GOOS) or stable dividend payers like Bank of Nova Scotia (TSX:BNS)(NYSE:BNS), using an RRSP can augment your gains by shielding you from pesky taxes.
These three tips will help you maximize your gains and minimize costly mistakes.
Start as early as possible I know you’ve heard this one before, but if you haven’t opened an RRSP, it’s the most valuable thing you can do today. You can always get the tax savings tomorrow by opening an account, but what you can never replace is something called the time value of money.
You’ve probably heard the phrase “time is money.” What you may not know is that it’s literally the case.
Let’s say you’re 40 years old and decide to start a nest egg. If you invest $10,000 per year at a 7% interest rate, you’ll wind up with $430,000 by the time you’re 60 years old. Not bad.
What if you had started when you were 30 years old? That would have added 50% more time to your investment period, but the gains would be much more. Your resulting nest egg would be worth more than $1 million!
That’s the power of compound interest. Every day that passes, you lose this incredible advantage.
Automate your contributions Once your account is open, you’ll only benefit when you make contributions. Trusting yourself to make regular contributions is a difficult bet to make. Instead, take the load off your future self and automate your savings.
In his best-selling book Nudge, Nobel Prize winner Richard Thaler writes about the magic of opting in versus opting out. For example, trusting yourself to opt-in every time you want to make an RRSP contribution means you’ll have to struggle with this decision multiple times per year.
But what if you only had to make the decision once?
By setting up automatic monthly withdrawals, your investments are made regularly without any action from you. Studies show that the chances of you “opting out” of this automatic investment are significantly lower than your odds of explicitly “opting in” each month without an automatic mechanism.
Plus, if you time it with your paycheck, you can build your life around this contribution with minimal impact.
Understand how to make withdrawals Making withdrawals can be tricky.
The easiest scenario is that you won’t need the money until you’re 71 years old, the age at which you’re required to make withdrawals. At that time, simply roll over your account into a Registered Retirement Income Fund (RRIF) or an annuity and make an annual withdrawal each year that meets the mandatory minimum.
But what if you take withdrawals earlier?
The most important thing to know is that any withdrawal you ever make will be taxed at your marginal tax rate. So if you made $40,000 in earnings last year and also take a $5,000 RRSP withdrawal, your taxable income will be $45,000.
And unless you want to have a tax penalty, don’t withdraw from your RRSP until you’re retired. The only ways to avoid this tax penalty is if you buy a home for the first time, buy a home for a disabled relative, or go back to school.
Fool contributor Ryan Vanzo has no position in any stocks mentioned. Bank of Nova Scotia is a recommendation of Stock Advisor Canada.
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