I wrote on Monday about how students should use an RRSP. In that I wrote that there is a much better account for students to utilize, the tax free savings account (TFSA). This is an account where one can hold investments of almost any sort, and these investments grow tax free and are not taxed when they are withdrawn. The contributions do not receive a tax credit, and those two points are where the TFSA and the RRSP differ.
A man who is much smarter than me, David Chilton, covered the issue of RRSP vs. TFSA in his recently released book The Wealthy Barber Returns. He has a chart in the book that shows that the same amount of money invested in the accounts over the same amount of years with the same rate of return, the accounts will have the exact same value. But the chart assumes that the money is taxed at the same rate when it is contributed as when it is withdrawn.
That is why the TFSA is the better option for students. All but the luckiest students will not get taxed very much while in school. I think it is safe to assume that everybody will be making a lot more money when they are near retirement than when they are in school. Right now I do not get taxed, but when I am withdrawing my RRSP I am sure to be paying at least some. The money will get taxed at the rate I am earning when I withdraw it, even though when I deposited the money I did not earn enough to have to pay income taxes. I just used the word “tax” way too much.
So that turns out to be a raw deal for a student. But I outlined ways where the RRSP can be useful. But the TFSA almost argues for itself.
The government has a site that explains the rules which you should also read but here is the gist:
– You are allowed to add $5,000 per year after you turn 18. I turned 18 in 2010 so I now have $15,000 of contribution room. The account was started in 2009 so if you turned 18 in 2009 or any year before that you have $20,000 of contribution room, that is the maximum. You start gaining contribution room even if you don’t open the account.
– You are allowed to withdraw from it anytime tax free and any money withdrawn gets added to your contribution room next year. So if I had $15,000 in my TFSA this year and then withdrew $2,000 to pay for some of my tuition or something, I would have $7,000 of contribution room for 2013.
Right now I have three TFSAs, all with TD. One is a TFSA mutual fund, one is a TFSA trading account which right now has two holdings, an ETF and a stock. The third is a savings account with a low 1.15% interest rate. While I have three accounts I still only have $15,000 of contribution room. The same thing applies if you have TFSAs at different banks.
When I went to open my RRSP my mom told me to also open a TFSA. I did not know what that was at the time. Maybe I am just ignorant, but I think that many young people will not be aware of this gift our government is giving us. If you are reading this you are most likely familiar with the TFSA, but there are lots of people who do not know about it and they are the ones who can benefit the most.
I think that at the very least a student should open a TFSA and use it as their primary savings account. Right now, as students, this is the ideal retirement/first house/new car/vacation/whatever you want account. It is perfect for long term goals such as retirement. The TFSA lets students keep as much of their money as possible. Investing in the TFSA allows them to keep all of their money that they invest now. After graduation the story changes a bit but, for probably the majority of young people, not just students, the TFSA is preferential to the RRSP.