Canadians have been asking for it for years and finally, beginning 2009 they’ll have a new tax-assisted savings vehicle—the Tax-Free Savings Account (TFSA).

The mechanics of the TFSA are relatively simple. All Canadian residents, 18 and older, will be permitted to contribute up to $5,000 annually. The contribution amount, which is not tax-deductible, will be indexed annually to inflation. If an individual does not contribute in a year or contributes less than the maximum amount, he can use that contribution room in any subsequent year.

Like RRSPs, income through TFSAs is earned free of tax. However, unlike RRSPs, that income is not taxed on withdrawal. Withdrawals can be made at any time and be used for any purpose, without attracting one penny of tax. And what’s more, any funds withdrawn from the TFSA (income and capital) are added to an individual’s contribution room and can effectively be re-contributed in any subsequent year.

This means that the TFSA can be used time and again to save for various expenditures over a lifetime. Consider an individual who begins contributing at age 18 and continues to deposit $5,000 for 10 years. Assuming a 10% annual return, he’ll have about $87,500 in the plan at age 28.

Say he marries that same year and his spouse has contributed in a similar manner. They’ll have $175,000 for a down-payment on a home. A successful professional couple with rapidly increasing earnings, they manage to pay off their mortgage in four years (by age 32).

After paying off the mortgage, they each have $107,500 TFSA contribution room and over the next six years, each contributes $23,000 annually, using up all their contribution room. By age 38, together, they have close to $400,000 in their TFSAs, which they withdraw and use to purchase a new car, upsize their home, and take a 10- year anniversary dream vacation; all without incurring debt.

They are good savers, and annually continue contributing $25,000 each over the next 10 years. This gives them combined savings of $875,000 at age 48, out of which they use $500,000 to purchase a cottage. They continue contributing for another 17 years at $20,000 each per year, resulting in a sum of $3.7 million at age 65.

Some clients may ask how the TFSA fits in with their other registered savings. What should their priorities be? While the TFSA is not intended as a replacement for the RRSP, it certainly can be used for retirement savings.

For individuals who are subject to lower marginal tax rates but expect their tax rates to increase in retirement, the TFSA will generally provide greater after-tax retirement benefits. However, the accounts have much lower contribution limits than RRSPs.

Young people just starting their careers often have limited funds for savings. And, if they expect their incomes (and marginal tax rates) to increase in the near future, they might consider contributing to TFSAs instead of RRSPs while their marginal tax rates are low. Once earnings and tax rates increase, the TFSA savings can be used to make RRSP contributions. In this manner, investment earnings are sheltered from tax immediately, and the tax benefit in relation to RRSP contributions is maximized. And remember, the withdrawals from the TSFA can always be re-contributed.

For individuals who are currently subject to the top marginal personal tax rate, and expect that rate to decline during retirement years, an RRSP will generally provide greater after-tax benefits. But, keep in mind that RRSP income could erode OAS benefits and the age credit, while TFSA withdrawals do not.

Ideally, people should use both RRSPs and TFSAs. If the TFSA is a supplement for retirement savings, drawing from the TFSA from ages 65 to 71 (instead of the RRSP) could increase the age credit and reduce the OAS clawback.

Originally published in Advisor's Edge