Uncommon Cents: Tax Free Savings Account ideal for students

Unique in the world of financial planning, the Tax Free Savings Account (TFSA) is one of many tools that help Canadians save for their financial goals.

The federal government introduced the TFSA in 2009. It is, however, misnamed. It should be called a Tax Free Investment Account. Some financial institutions will happily have you open a TFSA with them, as they take the third letter in the acronym literally by keeping your money in a savings account. What is wrong with that?

Savings accounts have very low interest rate returns (usually between 0.25 per cent and 1.4 per cent) often accompanied by high costs in terms of both fees and taxes. In addition, some financial intuitions will then take your money and lend it out at high rates to others. In other words, your money funds opportunities for some institutions to make large profits. but you suffer the indignity of poor performance and little financial gain. While there are some so-called higher-interest savings accounts (with interest rates between 1.35 per cent to 2.0 per cent) out there, their potential gains are still lower than other investments. Additionally, the inflation rate is around 2.0 per cent. So, any gains you might make are eaten up by the costs of living.

The only way to protect yourself is to know what you are doing, so ask questions, seek advice from more than one source and read the fine print.

TFSAs are a different beast. The growth on any monies you put into a TFSA will not be taxed at all. You can put your monies into virtually any form of investment, such as stocks, bonds and mutual funds, potentially getting a higher yield for your money. Since 2009, any Canadian who is 18 years or older may contribute up to $5 000 per year to a TFSA. The government has raised this limit to $5 500 as of January 2013. In addition, if any Canadian has not contributed any money to a TFSA since 2009, they can retroactively add that full amount to a TFSA without penalty (e.g., $20 000 since 2009).

Speaking of penalties: if you over-contribute, you will be subject to a fine, and if you withdraw any money in a given year, you cannot replace it until the following January. Short of these two rules, there is not a downside to this investment opportunity. Of course, if you choose to access this opportunity, you should do so on the basis of a comprehensive, intelligently thought-out plan based upon your risk profile and the time you have for investing.

There is, in general, a hierarchy for investing: first, max out your contribution to a Registered Retirement Savings Plan (RRSP); second, max out your TFSA contributions; and third, focus on non-registered investments (investments not registered with the government, such as stocks and bonds connected with companies). By following this pattern, you minimize, defer or eliminate payment of tax, thus putting more money in your pocket.

For students, the TFSA is an excellent opportunity to start saving because you have the potential to save more money as it grows using this instrument. An RRSP for students makes little sense because most students do not make enough money to save any taxes. If you put your money into a TFSA, you can begin growing your money, and once you are out of university and in a career, you can transfer all your TFSA earnings into a RRSP — when it will actually have a beneficial effect. Again, though, I cannot emphasize enough that any investments you make now or in the future have to be tied to your goals and concerns, your sensitivity to risk and your time horizon for investing.

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