Tax strategies using spousal RRSPs
Watch out for the three-year rule for withdrawals
Watch out for the three-year rule for withdrawals
Generally speaking, income splitting works best for families when two spouses are in different tax brackets. The classic case would be a high-earning female executive with a stay-at-home husband. As we saw in the previous article on pension income splitting, if this woman retires with a lucrative employer pension plan, it would be a no-brainer to split the pension income so half of it is taxed in the lower-taxed hands of the husband.
A similar principal is at work with spousal RRSPs. All those years the high-earning spouse is saving for retirement, the ideal solution would be to get a tax deduction for RRSP contributions but when it comes time to receive the income, to receive it in the hands of the lower-income spouse.
That’s exactly what a spousal RRSP does. The contributor can deduct the amount of the spousal RRSP deposit from his/her (higher) earned income, while the recipient (the husband in our example) owns the investments. The aim is to equalize retirement income of both spouses, and to have the RRSP funds withdrawn by the recipient spouse at his or her lower tax rate. Unlike pension splitting, you’re not restricted to splitting just 50% of the income: you can have 100% of it taxed in the lower-earning spouse if so desired. This income splitting also helps the couple each qualify for the $2,000 pension credit.
Chris Cottier, an investment advisor with Richardson GMP Limited, says the spousal RRSP is generally a “no-lose” proposition. Even so, personally, I’ve never used a spousal RRSP, since both my wife and I made decent money during our wealth accumulation years (and she still does). In my “Victory Lap Retirement” semi-retirement of recent years, I have considered using a spousal RRSP but am deterred because while my total RRSP is a bit smaller than my wife’s (she never had Pension Adjustments that lower contribution room), there doesn’t seem to be a great advantage to splitting it this late in the game: especially considering we will be able to split up to 50% of her future RRIF income to equalize our income as required.
I’m also deterred by the three-year rule for withdrawals from spousal RRSPs. If you fall afoul of this, the withdrawal amount may become taxable income for the contributor spouse. Because spousal RRSPs are meant for retirement, when it comes time to draw income from one it will be converted into a RRIF or an annuity. At that point, the income will be taxed in your spouse’s name at his or her tax rate. However, if your spouse withdraws funds within three calendar years of contribution, that amount will be added to your taxable income in the year of the withdrawal.
However, Warren Baldwin, senior vice president for T.E. Wealth, says the problems of the three-year rule can be easily avoided: “Just be sure not to ‘taint’ personal RRSP assets with any spousal-contributed funds; always have a separate RRSP for spousal contributions.”
Keeping an eye on the future is critical, agrees certified financial planner Aaron Hector, of Calgary-based Doherty & Bryant Financial Strategists: Shifting from Spousal RRSP contributions to regular RRSP contributions a few years before retirement may be worth considering if you plan to tap into your RRSPs when you finish working.
Since RRSPs will usually be converted to RRIFs by the end of the year you turn 71, many will interpret this as the end to RRSP contributions and their corresponding deductions. But that’s not necessarily the case, Hector says. Those who choose to work into their old age or those with any kind of ‘earned income’ (from, say real estate rental income or stock options) will continue to accrue RRSP deduction room. RRIF-aged people with younger spouses may be able to take advantage of this by contributing to their younger partner’s spousal RRSP until they are forced also into RRIFing.
If both spouses are 60 or older, they can choose to split CPP or QPP pensions equally. Warren Baldwin notes that in this case, the ability to split income is based on the term of spousal status compared to the contributory period. So, for example, if the spouses have been together only the last ten years but have contributed to CPP/QPP for 40 years each, only 25% (10/40) of the payments can be split.
Baldwin does not believe the more recent innovation of pension splitting lowers or eliminates the need for spousal RRSPs. “I think (and recommend to clients) that income splitting is a KEY benefit of spousal RRSP contributions. Pension income splitting is relatively new and could become a casualty of some future tax grab, perhaps even as soon as the next Federal Budget.”
Baldwin conjures up the specter of not using spousal RRSPs but using only personal RRSP and RPP contributions for ten years or so, expecting to income split after age 65 only to “find the splitting legislation is then cancelled. By contrast, “Spousal RRSP income splitting is pretty basic and has worked for many decades. Why be complacent and abandon it now? With Ottawa on the way to three or four times as much red ink this year than what was ‘promised,’ it would seem that income taxes can only get more expensive.”
While pension splitting and spousal RRSPs are the most-cited examples of family income splitting, there are others. Small-business owners often put both spouses on the payroll, provided that each is making a substantial contribution to the business. So if our female executive mentioned earlier also has a corporate side hustle, she could pay our otherwise idle husband a stipend to do marketing, sales, book-keeping, website work or whatever else he’s capable of doing. Business owners can review the pay mix of family members and find an optimum mix of dividends and salary, says Vancouver-based portfolio manager Adrian Mastracci of Lycos Asset Management Inc.
Another often-overlooked technique is prescribed loans from the high-income spouse to the lower-income one. As described by Mastracci, this involves paying the minimum 1% annual interest charge. (As Hector notes, interest MUST be paid within 30 days after the end of year, so interest on loans in place during 2016 would have to have been paid by the end of day on Jan. 30, 2017). Even though the higher-income spouse earns the money, this allows the lower-income spouse to invest the proceeds and have the resulting dividends, interest or capital gains taxed in his hands instead of his high-earning spouse.
A practical approach to family-income splitting is to invest all dollars earned by the lower-income spouse in their name, while the higher-income spouse should pay for all household expenses and credit-card bills.
Mastracci suggests clients think of income splitting in the same breath as their retirement planning. “In my view, the two camps ought to fit like a glove to deliver the best value.”
Jonathan Chevreau is founder of the Financial Independence Hub and co-author of Victory Lap Retirement. He can be reached at [email protected]
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