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TFSA – Don't Be Fooled by the Name

If you're still a bit vague when it comes to the latest entry in the alphabet soup of personal finance, you're not alone. Despite a serious marketing push by the banks and brokers, it appears that Canadians still find the Tax-Free Savings Account (TFSA) a bit of a mystery.

Consider one recent study. In focus groups commissioned by the Department of Finance, Decima Research found that participants indicated "minimal interest" in the new savings vehicle…until they gained a clearer understanding of how the tax-free accounts actually work.

TFSAs, which were established by the 2008 federal budget, allow Canadians to contribute up to $5,000 annually without being taxed on the interest income, dividends or capital gains earned within them. While the Decima study noted broad awareness, there was one key stumbling block. Few realized that TFSAs can invest in a wide range of financial products, including GICs, stocks and mutual funds.

It seems that many regarded the TFSA as just your average savings vehicle, churning out a paltry yield—simply one more account to keep track of. When viewed from that angle, no wonder it's of little interest. Not surprisingly, perception dramatically improved once this myth was dispelled.

In fact, misnomer aside, the TFSA is a closer cousin to the RRSP than your run-of-the-mill savings account. But where RRSPs give you an upfront tax deduction and shelter investment growth until the money is withdrawn, there is no upfront tax break with the TFSA. Instead, by funding the account with after-income-tax dollars, both investment growth and withdrawals are completely protected from further taxation.

Those interested can contribute $5,000 per person per year, which means couples can jointly sock away $10,000 a year between them. Over a ten-year period, that can add up to a substantial $100,000 or more of tax-free savings. And, unlike RRSPs, there are no minimum earned income requirements. The other nice aspect is that once you withdraw money from a TFSA, you can replenish the lost contribution room the following year—another area in which the RRSP falls short.

While TFSAs are suitable for a broad range of needs, we're finding them of particular interest among young people—especially when used in combination with the Home Buyer's Plan provision of the RRSP. Together, these two strategies will result in a larger down payment in the shortest amount of time and reduce the amount of interest ultimately paid on a mortgage.

So, if you dismissed the TFSA on the first go-around as just another acronym, you may want to take a second look.

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