Many people are used to paying their household bills on a monthly basis, a routine that keeps the lights and other services connected. But when it comes to savings and investing most individuals have a different approach. Often savings and investments take a back-burner approach.
The easiest way to implement savings and investments into your routine is to set up a pre-authorized contribution – often referred to as a PAC. This begins by looking at an investor’s monthly cash-flow and determining a comfortable amount to set aside.
So many financial illustrations trumpet the benefits of contributing early, even if those contributions are smaller. The compounding effects of investment returns are an important component to consider when developing financial plans. However, it is important to use realistic return expectations.
Some may be inclined to not do as much due diligence on investments with smaller dollar amounts. If a PAC is established, it is important to pick a quality investment and to monitor your investment regardless of its initial size. A quality PAC can turn into a significant nest egg over time.
Last week we mentioned that financial institution generally ask for a void cheque. The main reason is to obtain the institution, transit, and account numbers required to set up electronic transfers between financial institutions.
With a PAC, a person must make a few important decisions.
Decision 1: How much can you afford to contribute? Setting aside ten per cent of your monthly income may be a guideline to get some investors started. If this amount appears too high then consider decreasing the amount to five per cent or establishing a budget to monitor your monthly expenses.
Decision 2: How often would you like to contribute? Most investors who establish a PAC contribute either once or twice a month. We recommend that individuals consider their cash inflows and match the PAC accordingly.
Decision 3: What type of investment would be most appropriate to set up as a PAC? Some investors choose to simply contribute cash into their investment account. While others may choose to PAC into a money market investment or a mutual fund. There are a wide variety of investments to choose from. Some fund companies have established policies where an initial purchase of a set dollar amount (i.e. $500) is required to establish a PAC.
Decision 4: What type of an account would you like to PAC into? Many investors choose to PAC into a retirement savings account. If an investor knows their maximum Registered Retirement Savings Plan (RRSP) deduction limit then a PAC can be set to contribute this amount over the year. Another example may be parents who want to fund a Registered Education Savings Plan (RESP) through a $50 a month PAC.
Simple Strategy: Investors can ease the cash flow burden of trying to come up with their RRSP contribution limit every tax season. Let’s consider an investor that has a $16,000 RRSP contribution limit for the upcoming year. For this investor we recommend multiplying their RRSP deduction limit by 75 per cent and dividing by 12 to obtain the monthly PAC amount of $1,000. In either January or February of the following year, the investor could utilize their line of credit or obtain a short term RRSP loan to contribute another $4,000 to top up to the maximum. After filing the tax return, the combined RRSP contributions of $16,000 may provide enough of a tax refund to pay off the short-term loan or line of credit. This of course assumes that sufficient tax was withheld on other sources of income throughout the year.
It is important to note that a PAC can be cancelled or changed at any time. This may include changing the investment selection, frequency or dollar amount.
Most individuals find that after a few months they do not even notice the monthly amount being transferred from their bank account to their investment account – it has become as routine as paying the power bill.