Unlocking Free Money: Leverage Your Finances Smartly
Warning:
this post contains numbers and simple mathematics.
A lever is a simple machine that allows you to amplify an input force to provide a greater output force. That extra force is called leverage. The same principal can be applied to investing and is referred to as financial leverage. Traditionally financial leverage requires you to borrow money in the hope of making more money, but are there ways to access extra money without borrowing?
Show me the (free) money!
Is there such a thing as “free money”? Consider the following examples: the Registered Retirement Savings Plan (RRSP) and employer matched contributions to a pension plan. Here’s how they work.
The First Source of Free Money
RRSP’s give you free money through a tax shelter. Suppose in year #1 you put $5,000 dollars into an RRSP. At tax time you subtract that $5,000 from your taxable income, but remember you’ve already paid tax on that money. If your tax rate is 30%, you stand to get a $1,500 tax refund in year #2 (30% of $5,000).
You can now reinvest that tax refund and your regular $5,000 contribution giving you a total of $6,500 in RRSP contributions in year #2. In year #3 you get a tax refund of approximately $1,950 (30% of $6,500) which you reinvest into an RRSP for year #3 with your regular $5,000 contribution for a total of $6,950. You continue this exercise year after year gradually increasing your RRSP contributions.
If you keep your initial contribution the same ($5,000) the leveraged amount will decrease each year, so the solution is to gradually increase that contribution amount over your career (say for example if you get a raise or bonus). The higher your income is the higher your tax rate will be, and consequently the higher your refund on RRSP deductions.
The maximum leverage is achieved when your RRSP contribution reaches 18% of your previous year’s income or the 2023 capped amount of $30,780.
The Second Source of Free Money
The second way to access free money involves a company pension plan that offers employee matched contributions. That matching contribution is FREE MONEY to you, so be sure to get the maximum amount offered. For example, if your employer offers to match your pension’s contributions to a maximum of $5,000, you could contribute $5,000 with the result being a $10,000 total contribution. Continue this procedure year after year and you’ll realize a sizeable nest egg for retirement. This is one of the best sources of free money available.
What’s the Advantage of Doing This?
In both examples you are able to contribute more money than you actually have available using these plans. More money invested early will compound into a larger retirement nest egg. Taking maximum advantage of financial leverage could be the difference between an early retirement and having to work beyond the traditional retirement age of 65.
Maximize Your Money
Here are a few facts to keep in mind:
- You need to purchase well diversified investments for an RRSP and you’ll want to keep fees to a minimum to maximize your returns.
- Some pension plans are self-administered, meaning you have to decide what investments to buy. If you play it safe with bonds and you’ll be lucky to keep pace with inflation. You’ll have to do some research.
- Committing to saving money on a regular basis requires willpower and commitment. The golden rule is to save 10% to 20% of your gross income, depending on your age when you start saving.
- I’ve never met a person who was able to retire while paying off debt.
Too many people are intimidated by the prospect of managing their own money, but it is certainly possible to learn “just enough” to successfully plan and save for a secure retirement.
In my E-books (“Water Barrel” and “The Balance”) I discuss simple methods to live sensibly for today, take charge of your financial affairs, and invest safely for the long term. For more information please visit David Penna Amazon.
As always, I am not a qualified financial advisor. I just relate financial management to my own experience which may not resemble yours at all. Advice is frequently worth exactly what you paid for it. Most of mine came from expensive experiences.