Spouses get tax breaks that other taxpayers don’t due to the potential for income-splitting through spousal RRSPs and pension income-splitting. The latter, available since 2007, can help reduce household taxes in retirement but has many restrictions. A more flexible option, before and during retirement, is a spousal RRSP.
However, many older clients may be overlooking spousal RRSPs, partly because they are more focused on investment returns as they approach retirement. You can help your clients boost their household income by reviewing the possibilities for reducing taxes using these plans.
“When looking at investments, average people look at what return is being offered,” says Ernst & Young LLP tax expert Gena Katz, “without necessarily considering what the tax implication is.”
Spousal RRSPs offer a range of possibilities not available with pension income-splitting, notes Katz. For instance, pension income-splitting is limited to one-half of the recipient’s eligible pension income, and cannot be used until a certain age has been reached, depending on the type of pension being split. And, as it is only an allocation of pension income for the purposes of taxation, the lower-income spouse is not building capital. As well, if the spouses are in the same income tax bracket, there is no benefit to splitting pension income unless the transfer creates or increases the pension tax credit for the spouse receiving the pension income.
A spousal RRSP, on the other hand, is relevant for many more couples and can be used as an income-splitting tool well before retirement, says Katz. This strategy allows the higher-income earner to claim the tax deduction from an RRSP contribution now, while future withdrawals are taxed in the hands of the accountholder — the lower-income or non-working spouse or common-law partner. Contributions can be made to a spousal RRSP up to and including in the year that the accountholder turns 71, providing significant planning opportunities for couples in which the lower income spouse is also substantially younger than the contributing spouse. By using a spousal RRSP, the elder spouse can effectively direct income to the younger spouse at a lower tax rate.
For instance, a spousal RRSP could be used to lower taxes when the higher-income, older spouse continues to work or has other significant earned income well into his or her retirement years that can no longer be sheltered in his or her own registered plans due to age restrictions. Such income includes directors fees, investment income or income from real estate.
A spousal RRSP is also useful in preserving the old-age security benefit for low- to middle-income earners. For 2011, the maximum monthly benefit is $526.85, or $6,322.20 a year. The clawback on OAS benefits starts at net income of $67,668; OAS benefits are completely eliminated at an income of $109,764. If spouses can keep their respective income levels below the lower threshold through spousal RRSPs, they can avoid any clawbacks.
A word of caution about spousal RRSPs: there is a three year attribution rule, designed to prevent the higher-income earner from contributing to the spousal plan and having the funds almost immediately withdrawn and taxed in the hands of the lower-income earning spouse. A withdrawal is treated as income on the contributor’s personal tax return if it takes place within three calendar years of the last contribution. After the three-year period, the low- or no-income spouse can withdraw funds and pay little or no taxes, depending on their marginal rate.
Financial advisors, says Katz, should also remember that spousal RRSPs and pension income-splitting are not mutually exclusive, and can be combined to produce the most effective financial and tax results. IE