What Should I do with $100,000?
I follow a few Facebook pages that have to do with personal finance, retirement, etc. In a post, a man I’ll call Alan is 35 years old and has recently received a $100,000 inheritance that he hopes to use to build up his retirement savings. He wants to know how to invest the money to maximize its value by retirement. One of his first questions had to do with whether or not he should use a TFSA – he struggles with the limits imposed on contributions. For some reason, he is adamantly opposed to RRSPs. He also expressed an interest in GICs but sees them as a short-term option. and is, for whatever reason, adamantly opposed to RRSPs.
Alan’s Current Financial Picture
These are assumptions since we have no information about the rest of Alan’s financial circumstances.
Income and Expenses
Alan earns about $75,000 before taxes and benefit deductions. He pays a modest $1,500 in rent. As an active outdoorsman without a family, he spends a significant portion of his disposable income on recreational activities. He is also an avid fan of professional sports teams and follows the respective CFL and NHL teams in his home city of Winnipeg, attending as many games as he can.
Savings and Investments
Alan keeps $5,000 in his chequing account to cover his regular monthly expenses, replenishing it every pay period. He has $16,000 in a TFSA high-interest savings account. He considers that his emergency fund. He also contributes 5% of his pay to his employer-sponsored Defined Contribution Pension Plan (DCPP). His employer matches his contribution with another 5%. His DCPP is worth $110,000.
Other Assets
Alan’s vehicle is worth about $15,000 and his other personal effects are worth about another $5,000.
Considerations for Retirement Savings
Time Horizon
Let’s assume that Alan expects to retire at age 65, 30 years from now.
Investment Risk Tolerance
We do not have information on Alan’s risk tolerance, but let’s assume that it is moderate. With his 30-year time horizon in mind, a 75% equity position is about right.
Tax Implications
Despite Alan’s adamant refusal to consider an RRSP, the tax benefits of opening and contributing to an RRSP versus contributing to a TFSA need to be considered.
Future Contributions
Alan is not interested in discussing additional savings for retirement beyond the $100,000.
RRSP Contributions
Alan’s perspective on the RRSP is tainted by his parents’ complaints of having to pay taxes after they converted their RRSPs to RRIFs (Registered Retirement Income Funds) and started receiving their annual minimum payments. Alan did not consider, however, that the tax deferral continued in the RRIF for any of the money not withdrawn. Nor did he think about how big an impact an RRSP contribution could have on his taxes in any year that he contributed.
Because of the pension adjustment that occurs based on his DC pension plan, he has accumulated about $56,000 in contribution room. On $75,000 of gross income, however, that takes his taxable income well into the lowest tax rate, diminishing its relative benefit. Alan could instead contribute the full $56,000, but choose to claim only $28,000 as a tax deduction, claiming the remaining $28,000 in the following year. This would generate tax savings of about $8,201 each year or $16,402 in total (I am using 2024 rates throughout, courtesy of taxtips.ca). Claiming the full $56,000 in a single year would result in tax savings of $14,479. Alan can also target a slightly higher tax bracket and claim $11,633 for four years and $9,468 in the fifth year. This would result in $3,822 in savings for each of the first four years and $3,148 in the final year for a total of $18,436. All the while, Alan would be benefitting from the tax-deferred growth of the investments inside his RRSP.
Let’s assume that despite new contribution room, Alan will not do any more than the one-time $56,000 contribution to his RRSP.
TFSA Contributions
The TFSA does not provide a tax deduction for contributions, but it does allow for tax-free growth and withdrawals. With TFSA contribution room of $80,000, Alan could invest most of his $100,000 windfall into the TFSA and put the remaining $20,000 into his RRSP.
Alternatively, he could prioritize the RRSP, put in the maximum permitted $56,000 as described above, and use the remaining $44,000 to fund a TFSA dedicated to long-term investing, rather than an immediately accessible emergency fund. Let’s assume this second option.
Investment Projections
After expenses, a 75% equity /25% fixed-income investment portfolio can be reasonably projected to earn a nominal return of 5.50% per year. We now want to know how much Alan’s $100,000 could grow over the next 30 years. From his RRSP, with a $56,000 contribution, the estimate is $280,000. From his TFSA, starting with $44,000, the result is about $220,000, for a total of about $500,000.
Inflation-Adjusted Projections
If we assume “real” returns, that is after inflation is factored into the return, that 5.50% nominal return is reduced to 3.34%. This assumes long-term inflation will be 2.1%. In “real” dollar terms, that works out to about $270,000, $150,000 from the RRSP and $120,000 from the TFSA.
Estimated Income Projections
If we assume that Alan will be taxed at the lowest rate in Manitoba (combined federal and Manitoba rate of 25.80%) and that he expects to live to age 95, and therefore needs his retirement assets to last for 30 years, from his RRSP, which he plans to convert into a RRIF, he can withdraw about $8,000 per year, which, after tax, works out to about $5,900 per year. Alan’s TFSA, which will not be taxed, is estimated to generate about $6,400 per year over 30 years. An extra $12,300 in today’s dollars, is nothing to sneeze at!
Concluding Thoughts
When we consider the sources of income that Alan will have in retirement, his DC Pension plan, CPP, and OAS, the addition of an RRSP and a TFSA has the potential to help him out considerably. The following are my estimates of his retirement income.
While these numbers should be taken with a degree of caution, especially since I have introduced tax and inflation into my figures, they suggest that Alan would receive a considerable benefit from investing $100,000 as projected.
This is the 258th blog post for Russ Writes, first published on 2024-08-19
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