An Effective Income Tax and Retirement Saving Strategy
“I advise you to go on living solely to enrage those who are paying your annuities. It is the only pleasure I have left.” – Voltaire
RRSP income splitting is a highly effective income tax and retirement saving strategy that you can employ to better maximize you and your partner’s RRSP contributions and withdrawals. Sometimes a spousal RRSP is set up to better split income during retirement,meaning improved tax treatment for each at retirement with the added bonus of improved current tax rates for the higher income earner. Sound good? Here’s how it works: the higher income spouse simply makes a contribution to the other’s RRSP and claims the tax deduction (improved current tax rates). Now, with the investment becoming property of the other spouse, it is withdrawn in the future from the spousal RRSP at the lower income spouse’s tax rate(improved retirement tax rates).
Income splitting is a powerful strategy to apply to an already great retirement and income tax incentive that RRSPs represent. So much so that the temptation exists to use income splitting as a temporary tax saving measure, but be aware the government applies the rules of attribution to the tax splitting advantage. Any funds withdrawn from a spousal RRSP in the three years following the contribution and subsequent tax claim, results in withdrawn funds reverting back to the contributing spouse as income. Putting you back to square one, potentially even increasing your tax rates for that year.
Income splitting works because two moderate income streams are taxed less than a single income stream of the same total amount. If most or all of the family income is attributable to one person, it’s likely to be taxed at a high marginal tax rate. In addition, if both spouses have income from eligible sources, they’ll both be able to claim the federal pension tax credit.
A spousal RRSP is also a good way to split retirement income into two separate taxable streams rather than one large one. So, the benefit becomes four fold. Lower taxes for the two spouses when contributing and lower taxes for the two spouses upon withdrawal.
Let’s get creative here with some inventive uses of income splitting…
1) Are you unable to contribute to an RRSP because of age restrictions, but still want to benefit from the tax advantages? As long as an individual has earned income, a contribution to a spousal RRSP is still possible if the spouse is 71 or younger.
2) Retired persons earning more than $72,809 as of July 2016 face a reduced amount of government Old Age Security benefit on a graduated scale. At $118,055, claw back completely eliminates the OAS benefit. Through income splitting, claw back can be reduced or completely avoided by dividing income equally between spouses.
3) It is also allowable to split Canada Pension Plan income with your spouse. Doing this is worthwhile if spouses are taxed at different levels or when Canada Pension Plan benefits are considerably unequal. If both spouses receive the maximum CPP payment it won’t work, but as long as both spouses are at least 60 and there is a tax advantage, up to half of one spouse’s benefit payment may be transferred to the other.
4) Since 2007, senior citizen couples have been able to split eligible pension income. For those over 65, this includes lifetime annuity payments from a registered pension plan, an RRSP, or a deferred profit sharing plan. For those under 65, only annuity payment from a registered pension plan comply.
5) As a final note, by having the spouse with the lower income make investments, income can be split outside of an RRSP. This will help balance the retirement income stream as well. To do this, the higher earning spouse lends money to the other spouse for investments. Because interest is charged on the loan, the capital gains, dividend income or interest income earned are included in the lower earning spouse’s income, so that way any gains are taxed at a lower rate. The lower earning spouse also gets a tax deduction on the loan interest paid. The higher income spouse must claim the interest in income, so keep it minimal by charging the lowest rate allowed by law.
As you can see, income splitting in the right situations can lead to a few key tax breaks and help maximize your retirement savings plan. Considering the importance of this undertaking – it is the rest of your life we’re talking about here – it is wise to hire a financial planner or investment specialist to guide you along the way.