The TFSA program is beneficial to all, but is especially beneficial to the younger generation who have an unprecedented ability to use its tax-free compounding potential for many years. Let’s look at how the TFSA can be combined with stock investments, compounding through the “Rule of 72,” to build a self-sustaining retirement program.
Stocks are the second part of this dynamic trio. For simplicity I will target 10.3 per cent annual growth in a well-designed stock portfolio. The stock market has a century-long record of delivering this level of wealth creation. Many will argue that a 100 per cent stock portfolio is too risky, and this level of performance is unachievable. I addressed both those concerns in past columns. It took me a decade to learn success through simplicity as demonstrated by the “Titanium Strength Portfolio.”
Put in $6,000, Take out $192,000
The third part of the dynamic trio, the “Rule of 72,” can be used to calculate how the wealth creation ability of the stock market compounds inside a TFSA, propelling participants towards financial security. For this example, I’ll use 22 as the starting age. There are all kinds of financial needs at this time in life, but there were all kinds of financial needs for my generation as well, like 14 per cent mortgage interest. We’ll use the current $6,000 maximum contribution for the illustration. This may be a stretch for some.
Using the “Rule of 72,” we can calculate approximately what $6,000 compounds to over a 35-year career. How many doubles do we get? Take 72/10.3 per cent annual return = seven years to double your money. Thirty-five years divided by seven equals five doubles. $6,000 x 2x2x2x2x2 = $192,000. Therefore, if a person puts $6,000 in at age 22, they can take $192,000 out at age 57, with 10.3 per cent average annual returns.
For a self-sustaining program, put another $6,000 in at age 23 and take another $192,000 out at age 58. Put another $6,000 in at age 24 and take another $192,000 out at age 59, to continue for however long you contribute, and subsequently live. The TFSA can become your only necessary savings vehicle if managed correctly. I’m also a proponent of other tax-advantaged programs; RRSPs and RESPs, but the TFSA is my first priority.
Is $192,000 necessary or can we be less aggressive? First, this level of savings allows for some contingency if returns are lower than targeted. Second, we must always be cognizant of the two huge wealth robbers, inflation and taxes. The TFSA program takes care of taxes but not inflation. We can use the “Rule of 72” to calculate inflation impact on our portfolio. If inflation averages 2.05 per cent for 35 years what will things cost? Simply take 72/2.05 = 35 years. The price of things will double in 35 years. Therefore $192,000 will buy as much pleasure as $96,000 today, which provides a nice standard of living. Inflation is why stocks out-perform bonds so dramatically long-term. A three per cent bond will barely keep up to inflation. Using the “Rule of 72” we can calculate the real, after-inflation return on $6,000 invested at three per cent, with 2.05 per cent inflation. The outcome is about $8,750. Which would you sooner live on in 35 years: $92,000 or $8,750?
Googling “compounding calculators” will unearth numerous calculators to input various contribution amounts, frequency of contributions, returns, and length of period. Most of them are called, “compound interest calculators.” Rest assured they work on any compounding factor, including stock returns.
I used some broad generalizations in this column. It is my hope this example illustrates how to use the “Rule of 72” to make it applicable to your situation.