With the Conservative government recently backing away from plans to expand the options for income splitting, it’s a good time to revisit spousal RRSPs, a type of income splitting that can provide tax benefits for couples in a variety of situations.
A number of measures have been introduced over the years to allow retired Canadians to share their income with their spouse or partner and therefore pay less income tax. For instance, it's been possible to share Canada Pension Plan retirement benefits for more than a decade. The splitting of eligible pension income was introduced back in 2007.
Both of these measures have led some people to question whether it still makes sense to use an even earlier income-splitting measure – spousal RRSPs.
Well, the experts have an answer to that question. They all agree that, depending on the circumstances, a spousal RRSP can still offer potentially lucrative tax benefits for some couples.
The idea behind all income-splitting measures is to shift income from a family member in a higher tax bracket to a family member in a lower tax bracket. CPP sharing and pension income splitting allow for this, as does a spousal RRSP.
Spousal RRSPs allow the high-earning individual to contribute to their spouse's RRSP but claim the deduction themselves. When it comes time to withdraw the funds from the RRSP, the money is taxed in the hands of the spouse, as long as the contribution remained in the plan for at least two calendar years after the year in which it was first deposited. So, setting up a spousal RRSP can be a good idea if your spouse or common-law partner is likely to be in a lower tax bracket than you in retirement.
Here are four situations in which a spousal RRSP can provide a substantial benefit to taxpayers:
- You want to retire before age 65 — "There are limitations to pension income splitting," points out Wayne Drew, a tax partner with MNP in Waterloo, Ont. "For instance, spousal RRSPs can be used before age 65, but in the case of RRSP or RRIF income, you must be 65 or over to qualify for splitting." So, couples under 65 who want to retire early would be real beneficiaries from a spousal RRSP. Pension income-splitting rules also limit the splitting to 50/50. A spousal RRSP results in 100 per cent of the withdrawals being taxed in the hands of the spouse in the lower tax bracket.
- One spouse is older than 71 — Normally, you can't contribute to an RRSP in the year after you turn 71 even if you're still working. But if you have a spouse who is 71 or under, you can contribute to a spousal RRSP and still reap a tax break. "I've had many clients do that," Drew says, "As long as they have earned income from the previous year, this can be a great move for those over 71 who have younger spouses."
- You're saving to buy your first home — A spousal RRSP can allow both spouses to access RRSP funds to purchase a home. Under the Home Buyers' Plan, a first-time buyer can withdraw up to $25,000 tax-free from their RRSP to help them buy a home. A spousal RRSP can allow the other spouse — even one who doesn't work outside the home — to access another $25,000 in funds for the same purchase.
- One spouse wants to take a year off to have a child — Let's assume that a couple is planning to start a family a few years from now. The higher-income spouse can contribute to a spousal RRSP and get a tax break worth up to 45 per cent of the contribution. Then, assuming the three-year non-contribution period has been satisfied, the lower-income spouse can withdraw those funds and pay little or no tax. "This may be particularly advantageous in providing additional family funding when a lower-income spouse takes time off work, perhaps to raise children or start a business that isn't expected to earn profits for a number of years," says the accounting firm KPMG. It adds an important warning: unlike tax-free savings accounts, funds withdrawn from a spousal RRSP can't be recontributed to the plan at a later date without drawing down on future contribution room.
The experts say it's best to use tax software programs (or hire a tax professional) to figure out if any income-splitting or -sharing manoeuvre makes financial sense. That's because these type of moves have the potential to affect a whole range of other things, like Old Age Security clawbacks and the age amount tax credit. Tax software can optimize tax savings by suggesting the best method of splitting income.
Tax experts also say pension income splitting and spousal RRSPs are not either/or things. "Depending on your personal situation, the strategies can be combined in a manner to produce the most effective financial and tax results," notes Ernst & Young in the firm's online Managing Your Personal Taxes publication.