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.

RRSP-TFSA concepts & coordination

Your decision depends on many factors

Since its introduction in 2009, the TFSA has proven to be a powerful tool that opens up countless possibilities for improving our finances. However, when it comes to retirement savings, the RRSP should be the default choice for most of us.

Here are some important considerations to help you decide what’s best for you.

Tax treatment IN – Tax treatment OUT

The key difference between these plans is what happens on front and back end:

- RRSP deposits are pre-tax, income within is sheltered, and withdrawals are taxable
- TFSA deposits are after-tax, income within is sheltered, but withdrawals are not taxed

If you’re depositing to an individual RRSP, any associated refund must also go into your RRSP to keep it intact as ‘pre-tax’. For workplace group RRSPs, your employer does this for you through withholding tax.

Base comparison

If your income is taxed at the same rate when contributing to and withdrawing from the investment, your spendable cash will be the same either way.

Using $100 at a 40% tax rate and a 10% return (to allow for simple arithmetic):

However, if the withdrawal tax rate is reduced to 30%, the tax on the $110 in the RRSP will be reduced from $44 to $33, netting $77. On the other hand, if the withdrawal tax rate is 50%, the tax will be $55, netting to $55.

So, if you expect your tax rate to be lower when you will be taking withdrawals from this investment, choose RRSP. But if you expect a higher rate later on, choose TFSA.

‘Same rate’ – Marginal or average?

To assist in comparing rates, keep in mind we have a progressive tax system. That means higher income is taxed at a higher rate. An RRSP contribution gives you a tax deduction at your top marginal tax rate.

On withdrawal in your later years, the appropriate comparison is average rate, which is total tax divided by income. As average rate is mathematically lower than marginal rate, RRSP is usually the default choice.

What’s your own expected average rate?

In truth, your RRSP (in the form of a RRIF or annuity draw) will not be your only retirement income. You will have Canada Pension Plan and Old Age Security, and may have a pension, all together forming your foundation income. Thus, the average rate on your RRIF/annuity will be higher than your overall average.

And if you expect your retirement income to exceed the OAS clawback level, that will raise your effective marginal tax rate – that’s when it’s time to run the numbers through a financial planning spreadsheet!

Default choice, but with flexibility

To repeat, the point here is that RRSP is the default choice, but it could be displaced. Think of it in terms of proportionally allocating savings between them, not an either-or decision. Consider these factors:

Favouring RRSP

Most people live on a lower income in retirement. Spousal pension income splitting can reduce seniors’ household tax rate. The pension credit can reduce tax on $2,000 of RRIF/annuity income.

Favouring TFSA

Savings timeframe is shorter term, not retirement. Contributor is at low bracket at saving age. There are already significant RRSP assets. A large inheritance/winfall is confidently expected

TFSA – Tax-free savings account

Added flexibility for your tax-sheltered savings

The TFSA is a flexible savings plan that can be used – and re-used – for any savings purpose over a person’s lifetime. Qualified investments include deposits, guaranteed investment certificates, stocks, bonds, mutual funds and segregated funds.

Compared to other registered plans, the TFSA has relatively few rules to understand and follow.

Key tax features

Whereas RRSP contributions are deductible in the year made, and withdrawals are eventually taxable, for TFSAs:

- Contributions are after-tax, meaning they are NOT deductible in calculating income
- Income in the plan is tax-sheltered, unlike RRSPs for which income is tax-deferred until withdrawn
- Withdrawals are NOT taxed no matter when taken, and do not affect income-tested public support payments

Who can invest money in a TFSA?

To contribute to a TFSA, you must be a Canadian resident who is at least 18 years old and has a Social Insurance Number (SIN). Even foreign citizens who are resident in Canada qualify, though their home country rules may subject a TFSA to tax. If the age of majority to enter a contract is 19 in your province, the allotted TFSA room for age 18 carries forward to be used in a future year.

Unlike RRSPs which prohibit contributions after age 71, there is no upper age limit for TFSAs.

No tax applies if you become a non-resident of Canada, but you may not make contributions while a non-resident, nor are you credited with annual room. A 1% per-month penalty tax applies to non-resident contributions.

Contributions and withdrawals

From age 18, every Canadian resident is entitled to an allotment of annual TFSA room, which began at $5,000 in 2009. Other than 2015 when the annual room jumped to $10,000 (an election year goodie), that annual room is indexed in a way that rounds to the nearest $500 every few years, and currently stands at $7,000 for 2024. Unused room carries forward for use in any future year. For someone who has been eligible since the TFSA became available in 2009 but has not made any contributions, the cumulative room is $95,000 in 2024.

If you exceed your limit, there is a 1% penalty tax on your highest excess amount each month.

In addition to cash contributions, you may transfer securities in-kind to a TFSA, but the transaction may trigger tax. From a non-registered account, there is a deemed disposition at fair market value (FMV) that may result in a taxable capital gain, or if it comes from your RRSP it will be a taxable withdrawal at FMV.

If you borrow to contribute, the Income Tax Act (ITA) does not allow a deduction for the loan interest. This principle is based on the fact that the corresponding TFSA income is not taxable.

Credit for re-contribution

When you withdraw money from a TFSA, you receive a dollar-for-dollar re-contribution credit. This allows you to build savings and use them for a current need, and use that same room again in future. Be aware though that the credit is effective January 1st of the following year. If you plan to re-contribute sooner than that, make sure you have sufficient room separate from this credit, or you could be exposed to that over-contribution penalty.

Lifetime gifts and transfers

Generally, if you make a gift to a spouse/common-law partner (CLP) for investing, the ITA income attribution rules cause you the giver to be taxed on any resulting investment income. However, those attribution rules do not apply if the recipient spouse/CLP places that gift into a TFSA.

In fact, you can give money to anyone to contribute into their own TFSA, without any attribution concern. However, once money is in a TFSA, it cannot normally be transferred as a TFSA directly from one person to another.

But there is an exception that does allow for the transfer of a TFSA in the case of a spouse/CLP relationship breakdown. In that situation, the recipient spouse/CLP receives the transferred TFSA (which continues to be treated as a TFSA) and his/her existing contribution room remains as is. Unfortunately for the transferor spouse, the transaction does not result in a re-contribution credit.

Estate planning

Upon death, your TFSA will fall into your estate to be distributed among your estate beneficiaries. Alternatively, similar to other registered plans, you may designate one or more beneficiaries on your TFSA contract. (Note for Quebec residents that the law does not allow beneficiary designations on plans in that province.)

Money paid out through a TFSA beneficiary designation is tax-free to recipients, but the money is no longer in the form of a TFSA (except for a spouse/CLP, as discussed below). Those beneficiaries may use that money for whatever purpose they wish, including contributing to their own TFSAs to the extent of their available room.

Planning for spouse/common-law partner

There are additional options and benefits if you wish to leave your TFSA to your spouse/CLP. You can name him/her as “successor holder” of the TFSA upon your death, which can be recorded on the TFSA contract or be stated in your Will. This applies to the entire plan, and therefore cannot be mixed with a beneficiary designation. The plan will then continue on with your spouse/CLP as the new annuitant (the owner) and, as with a transfer on separation, his/her existing contribution room is unaffected.

The same result can be achieved if your spouse/CLP is named as a designated beneficiary on the TFSA contract (sole or along with others) or is a beneficiary of your estate, though more steps are involved (ie., joint tax elections with the estate). As well, if the TFSA flows through the estate then probate fee/tax may apply to the value of the plan in some provinces. Even so, in more complex estates such as second marriages or mixed families, it may be necessary to use one of these other options where contingencies need to be built into the estate planning.

Whatever option may be chosen, it is important to understand that unused TFSA room cannot be transferred to anyone, even a spouse/CLP. In effect, it dies with the person. That should be considered by a couple in deciding how to draw down their savings, especially in more advanced years or when managing with a terminal medical condition.