Canadian savers are using their self-directed RRSP accounts to set aside cash to fund a comfortable retirement.
Investors can use RRSP contributions to reduce income tax in the current year. That’s an attractive incentive for those in the highest marginal tax bracket, but it also makes sense for people in the earlier stages of their careers when you consider the diminishing purchasing power of money.
In short, it is better to pay the government $1,000 in 30 years rather than today, as the money buys more now than it will down the road.
The RRSP is also an appealing option for people who have a difficult time leaving their savings alone. In a TFSA, for example, it is easy to tap the funds for a vacation or a new car. Pulling the money out of your RRSP, however, triggers a tax payment, so you don’t get to use all the funds you want to remove, and depending on your tax bracket, the hit could be larger than if you left the money in the portfolio until retirement.
The other advantage of the RRSP involves the amount of money you can set aside. The government gives Canadians annual RRSP contribution space of 18% of their earned income, up to a limit.
For 2019 contributions, the maximum was set at $26,500. That would be 18% on 2018 earned income of about $147,000. It is important to note that contributions to a company pension plan count toward the 18% total.
TFSA limits currently increase by just $6,000 per year.
Why dividend stocks?
Top dividend stocks tend to be strong long-term performers for RRSP investors, especially when distributions are used to buy new shares. This strategy takes advantage of the power of compounding and can turn a relatively small initial portfolio into a significant retirement fund over time.
Let’s take a look at one stock that appear cheap today and has a solid track record of dividend growth.
Canadian Imperial Bank of Commerce (TSX:CM)(NYSE:CM) trades at just 9.1 times trailing earnings, and that’s after the recent bounce off the 2019 lows.
The company reported good results for fiscal Q3 2019 and better numbers should be on the way in the medium term. CIBC has done a good job of diversifying its revenue stream in the past two years, with more than US$5 billion spent on acquisitions south of the border. The new businesses should provide a nice hedge against the Canadian operations.
In Canada, the housing market is starting to bounce back, and this should be positive for CIBC, which relies heavily on lending to homebuyers.
What’s the upside?
The Bank of Canada has put its rate hikes on hold, and many market watchers anticipate a string of cuts in the next 12-18 months, in step with the U.S. Federal Reserve. The American central bank already cut its target rate in July and more reductions are expected in the coming months.
The market might not be appreciating the extent of the potential rebound in bank stocks, especially if the anticipated global economic slowdown doesn’t materialize and interest rate reductions are slow enough to boost borrowing, while still giving the banks room to book decent net interest margins.
CIBC just raised its dividend, so management can’t be too concerned about the revenue or earnings outlook. Investors who buy today can pick up a 5.5% yield with a shot at some nice upside when market sentiment improves. The stock trades at $103 per share compared to $124 in September last year.
A $10,000 investment in CIBC just 20 years ago would be worth more than $75,000 today with the dividends reinvested.
There is no guarantee CIBC will deliver the same results over the next two decades, but the stock deserves to be on your RRSP radar right now.
The bottom line
Dividend stocks can drive significant long-term growth in a self-directed RRSP.
Buying top companies when they are out of favour takes some courage, but the decision enables more shares to be purchased with the distributions, giving the compounding process a nice boost.
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Fool contributor Andrew Walker has no position in any stock mentioned.
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