Starting in 2009, a Canadian worker in the lowest tax bracket should consider using a Tax-Free Savings Account (TFSA) instead of an RRSP as a way to save for retirement.

The TFSA was the surprise announcement in the Feb. 26 federal budget.

Any Canadian who saves money or sells property or receives an inheritance should consider opening a Tax-Free Savings Account (TFSA) next year. Canadian residents who are 18 years of age or older will be able to deposit up to $5,000 annually to a TFSA.

Deposits will not be tax-deductible. But that's OK because there will be no income tax to pay on annual investment income accumulating inside the TFSA. Furthermore, there will be no income tax on any income or principal withdrawn from the TFSA.

Suppose, for example, you deposit $5,000 per year to your TFSA. Assume that your investments grow by seven per cent. After 40 years, your TFSA nest egg would be worth $1,000,000.

You can withdraw TFSA money tax-free to provide cash flow on top of your Old Age Security and Canada Pension Plan without reducing Guaranteed Income Supplement entitlement.

If you have no employer pension, your basic personal credit and age credit could be enough to eliminate all income tax liability.

Emergency fund

While you accumulate your TFSA nest egg for retirement, the account can double as an emergency fund. You can make tax-free, penalty-free withdrawals at any time. (A TFSA is more flexible than the Roth IRA plan in the U.S.)

The ideal emergency fund investment is easily cashable and provides safety of principal. A Canada Savings Bond (CS is a popular investment for this purpose. Of course, you normally receive fully taxable interest income from holding such investments outside of an RRSP. However, when a CSB is held inside a TFSA, there would be no interest income to report.

For example, what if you need to withdraw $3,000 from your TFSA for an emergency? The full $3,000 withdrawn can be re-contributed to the TFSA in the future.

Having a sizeable TFSA could allow you to increase deductibles on property insurance and waiting periods on disability insurance.

Sinking fund

You can use a TFSA to save for short-term goals such as a vacation, Christmas or your annual income tax bill.

Suppose you want to replace your automobile. You could deposit $5,000 every year (or $416 per month) and buy a $25,000 car every five years. Why not earn interest on your TFSA sinking fund instead of having to pay interest on a car loan?

Building a TFSA would be better than using a line of credit or credit cards to finance purchases.

TFSA or RRSP

For low-income Canadians, the TFSA will generally be better than an RRSP. As a rule of thumb, anyone earning less than $37,000 per year would probably make TFSA deposits rather than RRSP deposits.

A high-income Canadian would maximize both RRSP and TFSA.

Middle-income Canadians, with limited cash flow, would have to choose between TFSA and RRSP. For example, you could accumulate a TFSA emergency fund, while devoting the majority of savings efforts to the RRSP.

When the TFSA becomes available in 2009, your financial adviser can help you choose between TFSA and RRSP.

Over-contribution penalty

Most accountants hate completing the T1-OVP form for calculating the one per cent per month penalty on excess RRSP contributions. Note that the same stiff penalty rate also applies to a TFSA. You must not contribute too much to your TFSA.

Not life insurance

Over time you may be able to accumulate enough savings in your TFSA to cover emergencies and major expenditures. However, unless you are not insurable because of poor health, the TFSA will not be as good as life insurance for providing cash needed to protect your family in case of your premature death.

Terry McBride is secretary of the local chapter of Advocis (The Financial Advisors Association of Canada). He works at Raymond James Ltd., a member of the Canadian Investor Protection Fund. A recommendation of any strategy would only be made following a personal review of an individual situation. Seek independent advice for your tax-related questions.