When income drops, should we tap the RRSP and feed the TFSA?

Should we tap the RRSP and feed the TFSA?

If one partner is home with the kids, it sometimes makes sense to withdraw from an RRSP

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I’ve been contributing to a spousal RRSP while my wife stays at home with our four kids. She only has income that is provided from the government as child benefits. 

 Can I withdraw the maximum annual non-taxed amount minus the child benefits from the RRSP and deposit in her TFSA? This would eliminate playing taxes on eventual RRSP withdrawals.

 – Jeff

You ask a good question, Jeff. One of my financial planners had this question recently from a client and we evaluated the pros and cons. So, I think the answer may be of interest to others.

Everyone has a federal “basic personal amount” of income that they can earn tax-free without paying any federal tax. For 2018, this is $11,809. Their provincial or territorial basic personal amount varies by province or territory of residence but ranges from $8,160 in Prince Edward Island to $18,915 in Alberta for 2018.

So, most Canadians can earn at least $10,000 (sometimes much more) of income without paying any tax.

In your case, Jeff, your wife may be able to withdraw $10,000 or more tax-free from her registered retirement savings plan (RRSP). But if you aren’t careful, you could end up paying more than 50% tax on that withdrawal.

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Spousal RRSPs allow one spouse to contribute to an RRSP in the other spouse’s name. The contributor spouse gets the tax deduction and the spouse who owns the account eventually takes withdrawals to be taxed in their name. This works well if the contributor is in a high tax bracket and the accountholder will have less retirement assets and/or a lower future income.

The first thing to consider, Jeff, is whether you made contributions in the past three years to your wife’s spousal RRSP. If you contributed to the account in 2016, 2017 or 2018 and she takes a withdrawal in 2018, you may have to include some or all of the withdrawal on your 2018 tax return instead of hers. She could include in her income any part of the withdrawal that exceeded your combined 2016-2018 contributions, and if the contributions made exceeded the withdrawal amount, you would end up with the whole withdrawal on your tax return.

This happens due to spousal RRSP “attribution” rules that prevent withdrawals from being tax on the accountholder’s tax return if their spouse contributed in the past three years. If you’re in a high tax bracket, her withdrawal could be taxed as high as 54% on your tax return depending on your province or territory of residence.

Another consideration, Jeff, is that even if your wife can take the withdrawal out and have the income taxed in her name and offset by her federal and provincial basic personal amounts, your tax return will be impacted.

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This is because when your spouse has low or no income, you get to claim a spouse or common-law partner amount on your tax return. This tax credit results in tax savings of roughly 20%-25% of their income below the applicable threshold, which ranges from $6,931 in Price Edward Island to $18,915 in Alberta.

On that basis, your wife’s spousal RRSP withdrawal could cost you from 20% to over 50% tax, Jeff, whether indirectly due to a reduction in your spouse or common law partner amount tax credit or directly due to spousal RRSP income attribution. There could also be an impact on the child benefits you mentioned she receives or other federal or provincial credits, since her RRSP withdrawal would push up your family income used to determine eligibility.

The question is: would it be worth pulling the money out, even if it only cost you 20%?

To answer, I’ll give a simple example. Imagine your wife had $10,000 in a spousal RRSP and you had not contributed in many years, meaning no risk of attribution. If she takes a withdrawal, it may cost you guys 20% or $2,000 as a family. She invests that $8,000 in her Tax-Free Savings Account (TFSA) at 5%. In 10 years, it’s worth $13,031. She can withdraw that from her TFSA tax-free.

Related: RRSP vs TFSA: Which should you top up in retirement?

As an alternative, she could leave the money in her RRSP. She invests that $10,000 in her RRSP at 5%. In 10 years, it’s worth $16,289. If she’s in a 20% tax bracket at that time, her withdrawal would yield $13,031 after tax – the same as if she withdrew the money and put it into her TFSA in the first place.

In this simple example, it makes no difference what you do. There are some factors that could swing things in one direction or the other though.

If you guys had high-interest-rate credit card debt, taking the RRSP withdrawal may not be a bad strategy. If you were going to contribute to a Registered Education Savings Plan (RESP) for your children, which would result in a 20% government grant on your contributions, that might not be a bad strategy (20% better than the TFSA).

If your wife was going to be in a higher tax bracket in retirement – perhaps you have a large RRSP or defined benefit (DB) pension and can split your withdrawals with her in retirement – drawing down her RRSP now might make sense as well. Finally, if you have lots of RRSP room, a high tax bracket and can’t otherwise maximize your RRSP before retirement, pulling money from your wife’s RRSP at 20%, contributing to yours and getting, say, a 50% tax refund at your high tax rate is another potential strategy.

So, to wrap up my thoughts here, Jeff, there might not be a big difference whether you take the withdrawal now or later. It’s a bit complex and there’s no “one size fits all” answer. There are some situations where it could be beneficial. If it were uncertain, I’d be inclined to leave the RRSP as is and defer the tax.

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Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.