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I am often asked how a TFSA should fit into one's overall savings plan. The short answer? It all depends.

First of all, let me back up and explain exactly what a TFSA actually is. The Tax Free Savings Account (TFSA) was introduced by the Canadian government in the 2008 Federal Budget.

As of January 1, 2009, the Canadian government allows every Canadian, that is over the age of 18, to contribute up to a maximum of $5,000 every year to their TFSA account. The amount will be indexed to inflation but increases only in multiples of $500, therefore it remained capped at $5000 for 2010, and will probably not jump up to $5500 for the next year or two. Any unused contribution room can be carried forward indefinitely. For example, if you had contributed $2000 in to your TFSA account in 2009, you would be able to carry forward the $3000 of room not used last year giving you $8000 in room as of January 2010.

A TFSA itself is not an actual investment, but rather an account that is registered with the government similar to an RRSP, into which you can invest a wide range of qualified investment options such as, bonds, mutual Funds, GIC's, etc.

Your money grows tax sheltered while inside the TFSA and does not have to be withdrawn until death. There are certain provisions to allow for roll-over to spouses at that time. Contributions to a TFSA, unlike to a RRSP, are not tax deductible. The trade off is that you do not have to pay tax when you withdraw your money. You can withdraw all, or a portion, of your money at any time with absolutely no penalties or tax implications. The full amount of withdrawals can be deposited back into your TFSA in future years.

Let's say that you invested $5000 in mutual funds within your TFSA in January of 2009. As we know, the markets did very well last year and you watched your investment grow by 20% to $6000. You could withdraw the $6000 this year and never have to pay any tax on the $1000 growth. The same scenario in a non-registered account would add to your tax bill.

A key feature is that any income earned within a TFSA does not affect eligibility of federal income-tested benefits such as Old Age Security (OAS), the Guaranteed Income Supplement (GIS) and the Canada Child Tax benefit. In retirement, reducing your taxable income can be instrumental in avoiding claw-backs of government programs.

OK, so now that you know what a TFSA is, how should you use it? Depending on your situation, your TFSA could be used as part of your retirement plan or as a short term, tax-efficient, savings option. Here are some common uses:

Saving for a short term goal: A TFSA can be used to save for short term requirement; a down payment on a new home, an automobile, that new RV you're planning for in retirement or even to create an emergency fund. The flexibility of this account makes it ideal if you want to withdraw the money in the short term.

Saving for retirement: Use your TFSA to complement your RRSP in growing your nest egg tax efficiently. If you can maximize both your RRSP and your TFSA, you should. If that is not feasible, work with your financial planner to determine which vehicle works best in your particular situation. A lot will depend of your marginal tax rate year to year, as well as your expected tax rate at retirement relative to what rate you a paying now.

Reducing your taxes: Holding your income producing investments within your TFSA can save you tax dollars. This is especially valuable if you hold investments earning interest income as it received the least favourable tax treatment outside of a registered plan. An argument can also be made for holding speculative investments within your TFSA to grow your contribution room as large as possible if you happen to pick a winner. Keep in mind that capital losses incurred in TFSA's are not tax-deductible.

As years go by and the size of TFSA contribution room increases, it will play a more and more significant role in our retirement and saving strategies. Review your financial plan and make sure you are using every tool in your tool box to keep as much of your hard earn dollars in your pocket as you can.

The information in this article is not intended to constitute legal, financial planning or investment advice, and it may not be relied upon for such. Please seek specific professional advice with respect to your particular circumstances, as each client's financial situation is unique and solutions may vary. The strategies discussed herein are general. Mutual funds are not guaranteed and their values fluctuate on a daily basis. Investments may decline in value and investors may or may not receive back the original amount invested.