The federal government first made tax free savings accounts (TFSAs) available to investors in January 2009. These accounts let you earn investment income — including interest, dividends and capital gains — tax free. However, you could only contribute $5,000 in 2009 to start your tax free savings account.

Every year, you gain an additional $5,000 of contribution room (indexed to inflation and rounded to the nearest $500 on a yearly basis). 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.

(Read on for a simple strategy to help you choose between your TFSA and your RRSP, and cut your tax bill in retirement.)

Index funds are tailor made for your tax free savings account

Even though the limit is rising to $10,000, it’s still difficult to build a diversified portfolio within your tax free savings account. Instead, we continue to recommend that you look to index funds, like the iShares Cdn Large Cap 60 Index Fund (Toronto symbol XIU), for TFSA investing.

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The fund is a recommendation of our Canadian Wealth Advisor newsletter. Its 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.

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

RRSPs or TFSAs: Which should you invest in now?

Unlike RRSPs, TFSA contributions are not tax deductible. However, withdrawals from a TFSA are not taxed.

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.

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