Compound Growth in RRSP

[jess24]

I keep reading about these RRSP articles highlighting the magic of compunding interest in increasing the size of your RRSP at retirement.

Eg. "The power of time and compounding is truly the eighth wonder of the world," says Lovett-Reid. Most smart financial plans consist of nothing more than a regular practice of putting aside money (ideally through payroll deduction so as to remove temptation), then investing this money in a low-cost, well-diversified portfolio.

The results can be impressive, especially as you add more time to the mix. If you have 20 years to go before retirement and can put aside $200 a month into a portfolio that averages a 7% annual return, you will wind up with $100,000 at retirement. If you have 30 years to go, you will have $226,000."

I understand how compound growth works with basic interest income from a savings account or GIC that gets paid out at intervals - the magic being that you get interest on the already earned interest which grows to be a lot over time. But they key here is that you actually get paid the interest or the "gain" at intervals so that the next installment of interest is calculated from principal + last payment of interest.

My question is whether the magic of compounding works when all your RRSP $ is in mutual funds? If I just hold the funds until retirement and put my yearly amounts into new funds or to add to old funds already purchased, how can the magic of compiunding work? I'm not cashing out or selling my funds at the end of each year to realize gains. With funds, isn't it just the value of the unit that increases with no "interest" being paid. Am I missing something in my understanding?

Thanks

[Capt.]

realize gains

These are the most important words of your post. You're right, if you don't buy or sell your funds there will be nothing to tax.

However, let's say you decide after 5 years that you'd like to move your money to a different fund because the one you're one hasn't done much recently. If you are in an RRSP, you can sell your current funds and buy the new ones with no tax consequences. But if you are in a non-registered (taxable) account, you will have to pay on the gains you've made over the past 5 years.

I'd guess the chances are pretty good you'll move some money from fund to fund at least once over the timeline of your RRSP.

Note that this is also why it's preferable to hold interest paying investments and other securities that are not taxed as favourably in RRSP accounts.

[asdfvcx]

My question is whether the magic of compounding works when all your RRSP $ is in mutual funds? If I just hold the funds until retirement and put my yearly amounts into new funds or to add to old funds already purchased, how can the magic of compiunding work? I'm not cashing out or selling my funds at the end of each year to realize gains. With funds, isn't it just the value of the unit that increases with no "interest" being paid. Am I missing something in my understanding?

Yes, you are misunderstanding.

Say you buy $100 worth a fund.
If in year 1 it goes up 10%, how much is it now worth?

If in year 2 it again goes up 10%, now how much is it worth? (Think carefully about this one.)

[nickinto]

The concept applies to capital gains as well..assuming a 7% return rate:

Say you buy 1 mutual fund unit for $100 at year 1.

At Year 7, it is worth $100 x 1.07 = $107

At Year 14, your investment is worth $114.49

[dux]

The concept applies to capital gains as well..assuming a 7% return rate:

Say you buy 1 mutual fund unit for $100 at year 1.

At Year 7, it is worth $100 x 1.07 = $107

At Year 14, your investment is worth $114.49

Hmm I am pretty sure you meant at year 1, it is 107, and year 2 it's 114.49
At year 7, it's worth 100 * (1.07)^7 = 160.58
yeah 14, it's worth 100 * (1.07)^14 = 257.85


http://www.moneychimp.com/calculator/compound_interest_calculator.htm

[Thalo]

These are the most important words of your post. You're right, if you don't buy or sell your funds there will be nothing to tax.

However, let's say you decide after 5 years that you'd like to move your money to a different fund because the one you're one hasn't done much recently. If you are in an RRSP, you can sell your current funds and buy the new ones with no tax consequences. But if you are in a non-registered (taxable) account, you will have to pay on the gains you've made over the past 5 years.

I'd guess the chances are pretty good you'll move some money from fund to fund at least once over the timeline of your RRSP.

Note that this is also why it's preferable to hold interest paying investments and other securities that are not taxed as favourably in RRSP accounts.

Most mutual funds pay out some capital gains and dividends each year, so outside of an RRSP you would pay tax on them regularly.

Regarding interest paying investments, it's not favorable to hold them all else being equal. If your recommended asset allocation stipulates that you hold X amount in interest paying fixed income investments, then they are best held in the RRSP, with your equity investments best held outside of the RRSP.

[Capt.]

The dividends and capital gains paid out each year are generally pretty minor aren't they? Immaterial or borderline material at best I would guess.

Also I don't understand what you're trying to say about interest bearing holdings. What's "all else being equal" supposed to mean? Doesn't seem to fit with what we're talking about here. Were you just trying to elaborate on my point about holding interest bearing instruments in an RRSP? Or were you going another direction and saying don't hold them at all? Your statements are not clear to me.

[xlfe]

this thread is somewhat confusing.
it's not like most mutual funds (besides MMMFs) pay interest like savings account. these funds pay dividends but it's not really the same as interest. because your value doesn't increase when they pay you dividends. what increases your value of course is when the price jumps the assumed 7% every year or when you put more money in.

For me the two are very different. interests from savings, you get it every year, there's no way to go backwards and lose that interest. If we assume there are no distributions for a non MMMF, which in reality is rare or doesn't exist... the price could compound at 7% every year. but say the market crashes at year 15, then your screwed. you have the same number of units you started with and if the price falls down to the original purchase price...you've made nothing.

[Capt.]

the price could compound at 7% every year. but say the market crashes at year 15, then your screwed. you have the same number of units you started with and if the price falls down to the original purchase price...you've made nothing.

If you're in a fund that grows 7% annually for 15 years, the value would be 2.75 times what you started with. Very unlikely a market crash would reduce its value by 175%. 30-50% absolutely. Maybe even 80%. But a drop like that would be catastrophic. Millions would be out of jobs.

[Thalo]

The dividends and capital gains paid out each year are generally pretty minor aren't they? Immaterial or borderline material at best I would guess.

Also I don't understand what you're trying to say about interest bearing holdings. What's "all else being equal" supposed to mean? Doesn't seem to fit with what we're talking about here. Were you just trying to elaborate on my point about holding interest bearing instruments in an RRSP? Or were you going another direction and saying don't hold them at all? Your statements are not clear to me.

Actually, I don't quite get what I'm trying to say either. I think I was either drunk or very, very sleepy.

[xlfe]

If you're in a fund that grows 7% annually for 15 years, the value would be 2.75 times what you started with. Very unlikely a market crash would reduce its value by 175%. 30-50% absolutely. Maybe even 80%. But a drop like that would be catastrophic. Millions would be out of jobs.

dot.com crash...
but that's only an example because i was only trying to highlight a difference between compounding growth and compounding interest.

[VelociRacer]

...If we assume there are no distributions for a non MMMF, which in reality is rare or doesn't exist...

What about Dividend Re-Investment options with Mutual funds? Does that shelter you from any tax until you sell?