Recent surveys suggest that many Canadians are not saving enough to enjoy a comfortable retirement. With the overall population aging and baby boomers reaching retirement age, this is a serious concern. One way the Canadian government has reacted to this problem is by introducing the Tax-Free Savings Account (TFSA) in 2009.

The rules for a TFSA are simple. Every individual 18 years of age or older can contribute up to $5,000 (indexed for inflation) per year to a TFSA. A TFSA is basically the opposite of a Registered Retirement Savings Account (RRSP) where contributions are tax deductible, but withdrawals are fully taxable. This means that even though the RRSP may have earned capital gains over the years, the profits will be taxed on withdrawal as ordinary income. In contrast, there is no tax deduction for a contribution to a TFSA. However, not only do earnings accumulate tax-free inside the TFSA, but money can be withdrawn from the TFSA, at any time, free of tax.

Some people believe that a TFSA is not worthwhile because the annual contribution limit is only $5,000. However, consider this: even without taking into account the indexing of the $5,000 limit for inflation, maximum contributions over a period of twenty years at a 10% annual return will grow to $315,000. For a married couple, that’s $630,000. That $630,000 will mean $63,000 of tax-free retirement income, using the same 10% income assumption.

While you may think that 10% is a high rate of return, remember that a balanced portfolio generally will have a range of investments. Most people will have a fairly conservative portfolio in their RRSP to make sure that their retirement funds will be as safe as possible. This may allow a more aggressive portfolio for the TFSA, while still achieving a balanced overall portfolio.

Unlike an RRSP or a Registered Retirement Income Fund (RRIF), you can make yearly contributions to a TFSA for as long as you live and you can choose not to withdraw funds from the TFSA for as long as you like. Indeed, it may make sense to use RRSP and RRIF distributions and other sources of income as long as possible in order to build up the TFSA. This will provide maximum tax-free retirement income for later years. Also, if you designate your spouse as the survivor beneficiary under your TFSA, the TFSA will maintain its tax-free status following your death.

As with all savings plans, the key is to contribute as promptly and as often as you can. So if you don’t have your TFSA yet, what are you waiting for? As of January 1, 2011, you will be eligible to contribute $15,000 to a new TFSA.