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By Jim Middlemiss
Bankrate.com
January 10, 2007
When the federal government announced its plan in fall 2006 to tax income trusts, it also tossed in a perk to seniors that has gone largely unnoticed -- the ability to split pension income for tax purposes.
Adrian Mastracci, fee-only portfolio manager at KCM Wealth Management in Vancouver, says, "The goal of income splitting is to equalize retirement income so that the taxability of income is very similar in the hands of both spouses."
This policy change will cost the Canadian treasury about $1 billion and has huge implications for retired couples. It could also be a sign of things to come in future budgets under a Conservative government.
Finance Minister Jim Flaherty announced that starting in the 2007 tax year, the government will allow people receiving pensions to split their income with a lower-earning spouse.
Dave Ablett, a senior tax and retirement planning specialist, says while at first blush that move might seem to render spousal RRSPs -- which allow a higher-earning spouse to contribute to a lower-earning spouse's retirement plan -- moot, that's not the case.
Because of the limits on the type of pension income that can be split, investors still need to assess how they may be able to use spousal RRSPs to their advantage, he says.
The advantages of income splitting
Income splitting has long been considered a key strategy for trying to balance tax loads between spouses with substantially different salaries. Adrian Mastracci, a fee-only planner at KCM Wealth Management, in Vancouver, explains that the goal of income splitting is "to equalize retirement income so that the taxability of income is very similar in the hands of both spouses."
You do that by moving money from the hands of a higher earner into the hands of the lower earner so that it reduces the couple's overall tax burden, allowing them to pay less. While it can save high earners thousands of dollars in tax, there is little benefit to income splitting if both spouses make about the same amount of money.
The ability of Canadians to income split is fairly confined at present. For example, seniors are allowed to split their Canada Pension Plan, or CPP, income, but they must apply for permission to do so. However, you can't split Old Age Security, or OAS, payments or the Guaranteed Income Supplement, or GIS.
If you own a business, you can effectively split income by paying your spouse or kids a salary to do work for your company.
Other than that, the only other way to split income is with a spousal RRSP. Instead of contributing to an RRSP in your own name, the higher-income earner can contribute to a spouse's plan, where it will be taxed at what is likely a lower rate. The only stipulation is that the money can't be touched for three years after it is contributed, otherwise attribution rules kick in and the contributing spouse must claim it as income.
Lower taxes through splitting
So how will the Conservatives' new plan work? First, Ablett says, the pension money being earned must qualify for the pension income tax credit. For those over the age of 65, that includes payments from a periodic annuity pension fund, an RRSP, a Deferred Profit-Sharing Plan, or DPSP, or a Registered Retirement Income Fund, or RRIF.
If you're under 65, it includes payments from a pension plan, provided they are not lump sum payments, and annuity payments from a deceased spouse's RRIF, RRSP or DPSP. What it doesn't apply to in either case is a straight withdrawal from an RRSP. "You can't take out $2,000 from an RSP and use that for calculating pension income. It would not qualify," Ablett says.
He says spouses won't have to make actual payments to each other; rather, on their tax forms, the spouse transferring the money will claim it as income and receive a deduction and the spouse receiving the money will include it in computing his or her income. Both spouses must agree to the transfer and the allocation must be made one year at a time.
Ablett says depending on when a senior retires and the type of income he receives, spousal RRSPs still play a role in income splitting. "Some people will need to take funds from an RRSP prior to 65" in order to pay their bills and expenses, he says. In those cases, a spousal RRSP could help offset the tax burden by placing money in the hands of the lower-earning spouse.
As well, an RRSP might be a person's only means of income. That money doesn't have to be turned into a RIFF until you turn 69, so you have to assess whether you are better off drawing from a spousal RRSP to support your family until that point, as opposed to buying an annuity in an RRSP or moving it to a RRIF to create pension payments that qualify for pension splitting. The downside of an annuity is that it locks the money in at specific interest rates, which are currently at historic lows. So, it might be better to wait till rates rise before giving up that money.
As well, a spousal RRSP still allows money to grow tax-free, notes Mastracci, and that can be very powerful, especially for someone with a long investing horizon. Also, if you are over 69 and still earning income from a job and paying tax, you can't contribute to your own RRSP. However, if your spouse is young enough, you could contribute to his or her RRSP, which would offset the tax load as it applies to your salary.
While pension splitting is a welcome development, the bigger fish to fry is income splitting for all families -- a much more expensive proposition for government. Ablett says "it remains to be seen whether they will go for full income splitting. To do that, government revenues would have to continue to rise fairly substantially to pay for something like that."
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