TFSAs let you earn investment income — including interest, dividends and capital gains — tax free.

You could only invest $5,000 this year to start your TFSA. However, you gain an additional $5,000 of contribution room (indexed to inflation and rounded to the nearest $500 on a yearly basis) every year, plus you get to carry forward unused contribution room from previous years. (So in 2010 you’ll have $10,000 of contribution room, $15,000 in 2011, and so on.)

Use your tax free savings account to complement your RRSP

Your TFSA can generally hold the same investments as an RRSP. This includes cash, mutual funds, publicly traded stocks, GICs and bonds.

Contributions are not tax deductible, as they are with an RRSP. However, withdrawals from a TFSA are not taxed. This makes the TFSA a good vehicle for more short-term savings goals.

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If funds are limited, you may need to choose between RRSP and TSFA contributions. RRSPs may be the better choice in years of high income, since RRSP contributions are deductible from your taxable income. In years of low or no income — such as when you’re in school, beginning your career or between jobs — TFSAs may be the better choice.

Investing in a TFSA in low income years will provide a real benefit in retirement. When you’re retired, you can draw down your TFSA first, then begin making taxable RRSP withdrawals.

Hold low-risk investments in your tax free savings account

We think you are best to hold lower-risk investments in your TFSA. That’s because you don’t want to suffer big losses in these accounts. If you do, you can’t use those losses to offset capital gains. You’ll also lose the main advantage of a TFSA: sheltering gains from tax. You won’t have gains to shelter if the value of your investments falls.

Since this is the first year TFSAs have been offered, the $5,000 limit means you can’t yet build a diversified portfolio within these accounts. That’s why you are best to hold lower-risk and low-fee equity investments. These include interest-bearing investments, like high-yield savings accounts such as those from President’s Choice Financial or ING Direct, or index funds.

A tax free savings account-friendly index fund

One example of a suitable index fund is the iShares Cdn Large Cap 60 Index Fund (Toronto symbol XIU), which we follow in our Canadian Wealth Advisor newsletter. The fund’s units are made up of stocks that represent the S&P/TSX 60 Index, which consists of the 60 largest, most heavily traded stocks on the exchange. Most of the stocks in the index are high-quality companies.

The units trade on the Toronto exchange, just like stocks. Prices are quoted in newspaper stock tables and online. You’ll have to pay brokerage commissions to buy and sell them, but you will quickly make these back because of the low management fees, which are just 0.17% of the fund’s assets.

Take the long view with TFSAs

Over the years, as the value of your TFSA increases, you could switch to a well-diversified portfolio of conservative, mostly dividend-paying stocks, or mutual funds that hold those stocks.