Written by Puja Tayal at The Motley Fool Canada
Successful investors understand one important investing principle. Albert Einstein to Warren Buffett talk about its power to generate wealth. “Compound interest is the eighth wonder of the world. He who understands it earns it … he who doesn’t … pays it,” Albert Einstein famously said. If you earn compounding interest, you can become rich. But if you pay compounding interest, you will be in a debt spiral. In layman’s terms, you invest $100 and earn $10 interest. The next interest you earn is $11 on $110. You reinvest your investment loot and earn interest on interest. In the first few calculations, it might look small. But wait till retirement, and you will be wealthy.
Compounding works best when you invest and forget. You can use compounding to save for retirement and never run out of savings. The Registered Retirement Savings Plan (RRSP) and Tax-Free Savings Account (TFSA) allow your investments to compound tax-free.
The RRSP limit for 2023 is $30,780. If you have a lump sum amount stacked up and are worried about a heavy tax bill, you can invest $30,000 before the end of February and deduct it from your taxable income. Even if we take the minimum federal tax rate of 15%, this contribution will save you $4,500 in taxes.
How to use compounding to save for retirement
You can enhance your RRSP returns with a one-time $30,000 investment in Telus Corporation (TSX:T). The telco offers a dividend reinvestment plan (DRIP) that reinvests dividend amounts to buy more income-generating shares of Telus. Since the company is issuing DRIP shares, there is no brokerage cost. The company might also give a discount on the stock price. Investing through an RRSP makes your dividend tax-free.
If you invest $30,000 now, you can buy 1250 Telus shares that pay $1.515 in dividends per share. By the end of the year, your shares will earn $1,894 in annual dividends. This dividend amount could buy you 63.1 DRIP shares. In DRIP, you can also get less than one stock. At the start of 2025, you have 1313.1 shares that pay a $1.60 dividend per share. As your number of shares compounds, your dividend income compounds.
You invest $30,000 and forget it for 11 years. When you look at your RRSP portfolio 11 years from now, you might have 2,262 shares of Telus, giving a payout of $6,138 annually. Here’s how.
|
Telus Stock Price |
Year |
Annual Investment |
Telus DRIP Shares |
Telus Share Count |
Telus Dividend per Share (6% CAGR) |
Total Dividend |
|
$24.00 |
2024 |
$30,000.00 |
1250.0 |
1250.0 |
$1.5152 |
$1,893.96 |
|
$30.00 |
2025 |
$1,893.96 |
63.1 |
1313.1 |
$1.6061 |
$2,108.99 |
|
$30.00 |
2026 |
$2,108.99 |
70.3 |
1383.4 |
$1.7024 |
$2,355.21 |
|
$30.00 |
2027 |
$2,355.21 |
78.5 |
1461.9 |
$1.8046 |
$2,638.19 |
|
$30.00 |
2028 |
$2,638.19 |
87.9 |
1549.9 |
$1.9129 |
$2,964.70 |
|
$30.00 |
2029 |
$2,964.70 |
98.8 |
1648.7 |
$2.0276 |
$3,342.96 |
|
$35.00 |
2030 |
$3,342.96 |
95.5 |
1744.2 |
$2.1493 |
$3,748.82 |
|
$35.00 |
2031 |
$3,748.82 |
107.1 |
1851.3 |
$2.2782 |
$4,217.77 |
|
$35.00 |
2032 |
$4,217.77 |
120.5 |
1971.8 |
$2.4149 |
$4,761.86 |
|
$35.00 |
2033 |
$4,761.86 |
136.1 |
2107.9 |
$2.5598 |
$5,395.84 |
|
$35.00 |
2034 |
$5,395.84 |
154.2 |
2262.1 |
$2.7134 |
$6,137.91 |
If you retire in 2034, the Canada Pension Plan and RRSP’s $6,000 annual income can handle your monthly bills. Moreover, your $40,000 investment will compound your share count to 2,262 shares worth $79,000, assuming a stock price of $35. I won’t suggest going overboard with compounding in an RRSP, as the withdrawals are taxable.
Make retirement savings an absolute breeze with TFSA compounding
The TFSA doesn’t give you any tax benefit on contributions but makes withdrawals tax-free. In compounding, your end amount is gigantic compared to the invested amount, like a snowball rolling down a hill.
You can use the compounding power of Constellation Software (TSX:CSU) to enhance your TFSA portfolio. The company buys new vertical-specific software companies from the cash flows of the acquired company. It has created a constellation of mission-critical software companies that generate strong cash flows.
Constellation Software’s stock price has surged at a compounded annual rate of over 30% in the last 10 years. A $10,000 investment in February 2014 would be $146,859 today. The company is still compounding at a 30% rate. Even if this rate slows, the returns would be significant.
The post This is the 8th Wonder of the World, According to Albert Einstein: Utilizing it Correctly Can Help Make Saving for Retirement an Absolute Breeze appeared first on The Motley Fool Canada.
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Fool contributor Puja Tayal has no position in any of the stocks mentioned. The Motley Fool recommends Constellation Software and TELUS. The Motley Fool has a disclosure policy.
2024