As a result of the 2008 Federal Budget the concept of the tax-free savings account has been introduced to our tax lexicon. According to the folks at Finance, the idea behind this tax-free savings account is to improve the taxation of savings. Therefore, the question is: does this work? And, if so, how?

Here is the basic idea behind this new tax vehicle: Beginning in 2009, individuals who are at least 18 will be entitled to invest $5,000 per year in these tax-free savings accounts. The benefit of this investment is that any investment income earned in the account will not be taxable even when withdrawn. In that respect they differ from RRSPs as funds pulled out of an RRSP are taxable. However, unlike with RRSPs, contributions to these savings accounts will not be deductible.

The $5,000 per-year contribution limit begins to accumulate in 2009 and carries forward if it is not used. It also gets refreshed if funds are withdrawn from the account. Furthermore, the annual contribution limit will be indexed starting in 2010.

As with all matters relating to the Income Tax Act, this concept comes burdened with complicated legislation and traps for the unwary. There are a number of details which must be followed to avoid inadvertently triggering tax and/or penalties.

The tax-free savings account must be a "qualifying arrangement." In simple terms this means an instrument held by a bank or trust company or an annuity contract with an insurance company. The financial institution or insurance company is known as the "issuer." The issuer must file an election with the CRA before March of the following year to register the arrangement. Failure to file will result in the arrangement losing its tax-free status.

The account can only be for the benefit of one person while that person is alive. The rights to an account can be passed on death to a spouse or common-law partner through a beneficiary designation, if available, or through a Will. If it is done through a Will there could be additional complications to ensure that the tax-free status continues.

As with an RRSP, tax-free savings accounts are limited to qualified investments. These investments include term deposits, GICs, government bonds, publicly traded stocks on a Canadian exchange, etc. Investing in a non-qualified investment can trigger tax and penalties.

In addition to the qualified investment issue, tax and/or penalties may result if excess contributions are made, a business or businesses are carried on within the account or if anyone other than the holder receives a benefit from the account. So while the idea is that these accounts are a tax-free investment vehicle, care must be taken to ensure that this special status is not compromised.

The "go-live" date for the use of tax-free savings accounts is just around the corner so people should be considering their planning opportunities. If anyone can afford to maximize both their RRSP and tax-free savings contributions then they should go for it. If there is a need to allocate between the two, a quick analysis assuming equal tax rates on the RRSP deduction and withdrawal will show that using an RRSP versus a tax-free savings account will result in the same after-tax rate of return. From that standpoint the decision is tax-neutral. However, generally the tax rate on the RRSP deduction will be higher than the tax rate on the withdrawal. In those circumstances the RRSP will be the more favourable vehicle. One cannot really go wrong by maximizing the RRSP if available. One can look at the tax-free savings account as an added bonus but they must be sure to use it properly or lose the benefit.

Harold Feder is a partner with the law firm of BrazeauSeller.LLP. He practises in the areas of tax and estate planning for individuals and business owners. Harold can be reached at 613-237-4000 ext. 242 or at hfeder@brazeauseller.com. For more information about Harold, visit www.brazeauseller.com.

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