iTIPS* – Capital gains protector

Recovering the tax, to make investments whole

⇒ Candidate profile

The total return on an investment is the sum of the income it pays, and the change in its price —hopefully upward — while it is owned. The more familiar term for a price increase is a capital gain. From a tax perspective, only half of a capital gain is taxed, and that tax is not levied while the price is rising, but rather when the investment is sold. That’s why long-term investors usually prefer less distributed income, so that they have more exposure to a price rise, and eventual capital gain.

⇒ Financial challenge

This untaxed buildup is known as an unrealized capital gain, further rewarding an investor by deferring tax for years and possibly decades. If it’s all sold in one year, the income inclusion will push into higher tax rates on the higher income, so instead the investor may plan to sell in stages, triggering only a portion of the gains each year. But even that can’t go on forever. When the investor dies, the remaining investment is deemed to be sold, with a potentially hefty tax bill to follow.

⇒ Highlighted features

For married spouses and common law partners, there is some tax relief. Investments are capital property that can pass from one to the other at its adjusted cost base. This applies to transfers both during lifetime and at death, the latter sidestepping that deemed disposition on a first death. Still, this does not eliminate the tax, though it does extend the time when it can be expected to land. A cost-effective way to neutralize the tax is for the couple to obtain joint-last-to-die (JLTD) insurance.

⇒ Planning strategy

JLTD insurance premiums are based on the two (or more) people whose lives are insured on the policy. Statistically the insurer expects to pay out later than if there had been distinct coverage on each person, which then leads to a lower premium. The face value / death benefit will be based on the estimated tax arising on the second death, aligning the insurance receipt with when it will be needed. This concept is based on capital gains generated in a non-registered account, but it applies similarly to RRSP/RRIF rollovers taxed at a second death.

* iTIPS = Illustrated Tax & Insurance Planning Scenarios
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TFSA room indexing – Anticipating the acceleration

The compounding frequency of annual increases

Since inception in 2009, the TFSA has had annual room increases about every five years – that is until the back-to-back bumps in 2023 and 2024 that brought the annual allotment up to its current $7,000 figure.

The annual room of $6,000 in 2022 would have elevated to $6,500 in 2023 with as little as a 1.5% rise in the consumer price index (CPI). As it turned out, 2022’s high inflation pushed the indexation factor to over 6.3%, contrasting sharply with the sub-2% annual average for the preceding 15 years since the TFSA was launched. That was followed up with a 4.7% CPI for 2023, helping explain why we saw increases in two consecutive years.

This is more than just a walk down economic memory lane. The way that the indexing formula is structured, it’s arithmetically inevitable that we’ll see more frequent annual increases in TFSA room as the years roll forward.

The TFSA indexing formula

One of the distinguishing features of the TFSA is how it is designed to keep up with inflation. Like many other elements of our tax system, it makes use of an indexing formula, but one that operates unlike those others in that changes in annual TFSA room don’t necessarily happen annually.

The indexation factor is in section 117 of the Income Tax Act. For a coming year, it is the average of the CPI for the 12-month period that ended on September 30 of the current year, divided by the average of the CPI for the 12-month period that ended on September 30 of the preceding year.

For things like income tax brackets and RRSP room, that factor applies directly to increase the respective element every year. The same indexation factor is used for the TFSA, but it’s an indirect calculation, such that changes to TFSA room only occur every few years. The factor augments a background reference figure, and only once that figure rounds to the next $500 level does actual TFSA room rise by that amount.

Bear in mind that the first move required just a half-step of $250 for the reference figure to cross $5,250 and force the round-up to $5,500. After that (and leaving aside the one-time doubling to $10,000 in the 2015 election year), the $500 increment was applied two more times to take us from the original $5,000 room in 2009 to $6,500 in 2023. Again, that’s about five years on average, before this one-year quick step in 2024 to $7,000.

A beneficial byproduct of this two-stage process is that TFSA room is always a round figure. While being careful not to overstate the case, this simpler expression may make TFSAs more understandable and accessible for those who may feel intimidated by tax minutia.

Frequency of future increases

Now consider that at the beginning, that $500 increment was 10% of the original $5,000 room. That same $500 is now just 7.1% of the current $7,000 room. With an ever-higher base upon which to apply the indexation factor, the number of years required to reach future levels will continue to compress.

We can observe this with an example that applies a consistent 2% indexation factor, which would match the Bank of Canada’s (BOC) long-term inflation target. Assuming a current reference figure of $6,861 in 2024 (an unofficial approximation based on the CPI rates since 2009), it will take four years to step up to $7,500, and just three years to hit $8,000, with continuing narrowing in following years.

On the other hand, if the recent high CPI foretells a period of sustained higher inflation (hopefully not!), then those jumps could be compressed even further. By my calculation, if CPI hovers around 3% (the high end of the BOC inflation target range), we could soon see TFSA room increasing every other year. As appealing as that may sound for the TFSA, it would be exceedingly disruptive to living expenses, meaning less cash available to take advantage of that increased room.

Accumulated unused room

Though the original $5,000 of annual TFSA room may have seemed modest when the program launched, there is now momentum to its indexed increases. And with the benefit of unlimited carryforward of unused room, the TFSA is likely to become an even more prominent financial tool for many people.

In fact, another way to look at indexing is to consider how the addition of room each year effectively indexes accumulated unused TFSA room. With the $7,000 of annual room credited for 2024, accumulated unused room stands at $95,000. For someone who has not yet taken advantage of their TFSA capacity, that’s an 8% increase to their waiting tax sheltering room.

One cohort for whom this could be especially apropos is couples who were early homeowners when the TFSA was introduced. Mortgage payments will have dominated their monthly budgeting in the intervening years, but now they’re likely seeing light at the end of that tunnel. Through accelerated bi-weekly payments they will have been able to reduce the amortization of a 25-year mortgage by almost eight years. Give it a couple more years and that extra household cash flow will align nicely with the combined $200,000+ TFSA room waiting to be exploited.

CPP premium increases through 2025

Final steps in a decade of CPP enhancements

We’re entering the final year of Phase Two of the Canada Pension Plan (CPP) enhancements announced in 2016. Over the long term, these enhancements are designed to increase the CPP income replacement level from one-quarter to one-third of eligible earnings.

Phase One ended its five-year run in 2023

Phase One, which began in 2019, increased employer and employee contribution rates by 1% over five years. The 2023 increase of 0.25% brought the cumulative increase to that target full percentage point from the 4.95% starting level in 2018 to 5.95% for 2023 and following years. For the self-employed, who bear both parts of the premium obligation, it’s been double the ascent from 9.9% to 11.9%.

The rate is applied to the year’s maximum pensionable earnings (YMPE), which is $68,500 for 2024. At that rate, the maximum contribution is $3,867.50 each for employer and employee. Self-employed individuals pay both parts, totaling to $7,735.00.

Personal budgeting from 2023 onward

Over the five-year phase-in period, that cumulative 1% addition to the prevailing 4.95% rate worked out to an increase of just over 20%. While each annual addition over the five years may not have been all that noticeable to workers, in total it eroded as much as $631 on a person’s annual paycheque in 2023 from what it would have been without the changes. For those self-employed it’s as much as double that, or $1,262.

Keep in mind that, though some people may call it a ‘payroll tax’, it truly is a premium payment that contributes to that person’s own CPP retirement pension down the road. As well, on a current basis employees get some relief when they claim a tax credit for CPP premiums paid when filing their annual income tax return, and for the self-employed the employer-side premium is deductible against business income.

Still, this bit of imposed belt-tightening does reduce current annual cash flow, which could present a budgeting challenge for those living close to the financial edge. Things may have gotten even tighter yet coming into 2024 as Phase Two of the changes began to apply to those with income over the YMPE, which is where we turn next.

Phase Two runs for 2024 and 2025

Phase Two adds a second earnings limit beyond the YMPE, to be called the year’s additional maximum pensionable earnings (YAMPE). The YAMPE begins as 107% of the YMPE in 2024, then moves to 114% of YMPE in 2025 and later years. After that, the YMPE and YAMPE thresholds will be separately indexed, but using the same standard indexation factor, so the YAMPE will remain at 114% of YMPE ongoing.

Employer and employee contributions up to the YMPE will continue at the 5.95% rate, while the rate between the YMPE and YAMPE will be 4% each. All contributions are deductible for employers.

Employees will continue to claim a tax credit on contributions up to the YMPE, with contributions between the YMPE and YAMPE entitle them to a deduction. A deduction better aligns to the employee’s cost since it’s effectively at the individual’s marginal tax rate, rather than the lowest bracket rate accorded to the credit.

The YAMPE for 2024 is $73,200, being 107% of the 2024 YMPE of $68,500. The difference between the two is thus $4,700, which means that the maximum additional premium for each of employer and employee in 2024 comes out to $188 once the 4% rate is applied. Alternatively, if the employee’s income is less than the YAMPE, the additional premium is based on income minus YMPE, so for example at $69,000 in 2024 it would be 4% of $500 = $20.

Will the pandemic prompt more CPP changes?

The CPP is funded by employer and employee contributions. Excess cash flow is invested by the CPP Investment Board in financial markets to fund anticipated future cash shortfalls as the ratio of beneficiaries to contributors rises due in large part to the ageing of the Canadian population.

In its fiscal sustainability report in 2020 – in the midst of the Covid-19 pandemic – the parliamentary budget officer (PBO) raised the spectre that additional funding may be required for the CPP. At the time, the PBO estimated that increased contributions or reduced benefits amounting to 0.1% of GDP may be required for the CPP to meet its 75-year sustainability metric. In subsequent fiscal updates in 2021 and 2022, the PBO was no longer seeing a fiscal gap in the 75-year measure.

Still, the pandemic brought to light how the economy can be disrupted by unpredictable (or at least unpredicted) events. As the economic settles into a more normalized condition post-pandemic, economists and policymakers will eventually revisit the CPP (it’s actually required to be reviewed triennially), so we may yet see further CPP adjustments beyond the current enhancement process.