Inflation, Interest Rates Will Have a Surprising Effect on Your Taxes Next Year
The Bank of Canada’s decision this week to hold its benchmark interest rate steady at 5% as it attempts to battle inflation was welcome news for many. But the effects of both higher interest rates and inflation on the tax system will be felt in the new year in at least a couple of ways based on recent economic data available over the past week or so.
First, let’s start with the interest rate environment. It appears that even though the central bank’s rate isn’t rising, the Canada Revenue Agency’s prescribed interest rate will indeed increase (yet again) as of Jan. 1, 2024. The prescribed rate is set quarterly and is tied directly to the yield on Government of Canada three-month Treasury bills, but with a lag.
The calculation is based on a formula in the Income Tax Regulations that takes the simple average of three-month Treasury bills for the first month of the preceding quarter, rounded up to the next highest whole percentage point (if not already a whole number).
To calculate the rate for the upcoming quarter (Jan. 1 through March 31, 2024), we look at the first month of the current quarter (October 2023) and take the average of the three-month T-bill yields, which were 5.16% (Oct. 10) and also 5.16% (Oct. 24). Since the prescribed rate is then rounded up to the nearest whole percentage point, we get 6% for the new prescribed rate for the first quarter of 2024. Contrast this with the historically low rate of 1% we had from July 1, 2020, through June 30, 2022. The last time the prescribed rate was 6% was more than 20 years ago in the second quarter of 2001.
The hike in the prescribed rate has a number of implications. To understand these, we should point out that there are, in reality, three prescribed rates: the base rate, the rate paid for tax refunds, and the rate charged for unpaid taxes. The base rate, which will be increasing to 6% (from 5%) on Jan. 1, applies to taxable benefits for employees and shareholders, low-interest loans, and other related party transactions.
The rate for tax refunds is two percentage points higher than the base rate, meaning that if the CRA owes you money, the rate of interest will be 8% as of Jan. 1. Note, however, that rushing to file your 2023 tax return as early as possible next tax filing season won’t necessarily get you that rate on your refund, because the CRA only pays refund interest on amounts it owes you after May 30, assuming you filed by the deadline.
Finally, if you owe the CRA money, or if you’re late or deficient in one of your quarterly tax instalments, then the rate the CRA charges is a full four percentage points higher than the base rate. This puts the interest rate on tax debts, penalties, insufficient instalments, unpaid income tax, Canada Pension Plan contributions, and employment insurance premiums at a whopping 10% come Jan. 1.
Keep in mind that this interest is compounded daily and is not tax deductible. For example, if you’re a resident of Newfoundland and Labrador and in the highest 2023 tax bracket of 55%, that means you’d have to find an investment that earns a guaranteed, pre-tax rate of return of 22% to be better off than paying down your tax debt.
The other recent economic news that will impact taxpayers in 2024 is the latest inflation number. The tax brackets and most other amounts in the tax system are indexed to inflation. While the inflation indexation factor for 2024 that will be applied to the tax brackets and various other amounts won’t officially be released by the CRA until November, we can do a rough calculation based on the consumer price index (CPI) data released by Statistics Canada last week.
The federal indexation factor for 2024 is calculated as the average of the monthly CPI numbers for the 12-month period ended Sept. 30, 2023, divided by the average of the monthly CPI factors for the 12-month period ended Sept. 30, 2022. The September CPI data released last week showed a 3.8% increase over the past 12 months. We can then use this data to finalize the 2024 indexation factor, which should come in at 4.7%. By comparison, the 2023 indexation factor was 6.3%.
The silver lining in the latest inflationary number is that the tax-free savings account (TFSA) limit for 2024 should go up to $7,000, an increase from the current 2023 limit of $6,500. Note that this marks the first time the TFSA limit has risen in two consecutive years, as it was $6,000 in 2022.
The TFSA was first introduced in the 2008 federal budget and became available to Canadians for the 2009 calendar year. Its initial limit of $5,000 rose to $5,500 and stayed there for a number of years, with a short-lived flirtation at $10,000 in 2015. Under the tax rules, starting in 2016 and for each subsequent year, the annual TFSA dollar limit was fixed at $5,000, indexed to inflation for each year after 2009, and rounded to the nearest $500, which makes the annual limits easy to remember.
The TFSA limit only gets increased, therefore, when the cumulative effect of the annual inflation adjustments is enough to push the limit to the next highest $500 increment. The indexed TFSA dollar amount for 2024 is now at $6,859, meaning that the official limit gets boosted to $7,000, the closest $500 increment.
For someone who has never contributed to a TFSA and has been a resident of Canada and at least 18 years of age since 2009, the total contribution room available in 2024 will rise to $95,000 from $88,000 in 2023.