Pension income splitting

Pension income splitting
by Kevin Keith - 4, 2007

Every day, the media is discussing the latest announcement, policy change, or proposal made by government. Some may grab our interest, some may not; regardless, these topics tend to fade quickly from our minds as we are flooded with the new topic of the hour. There was recently an announcement that made many people sit up and take notice. And if it has since faded from your mind, I would like to refresh your memory.

The announcement I'm referring to was made by the Federal government in October 2006. In his announcement, Finance Minister Jim Flaherty revealed new tax rules which will allow spouses to split pension income earned in 2007. This is an important announcement because it will allow many Canadians to significantly lower their taxes.

What is income splitting? Income splitting is a tax-saving strategy that can be used by spouses in different tax brackets. Income is shifted from the higher-earning spouse to the lower-earning spouse; this income is then taxed at a lower rate. Income splitting is generally not allowed in Canada; there are strict rules surrounding the practice. There are only a handful of ways that the tax laws will allow couples to split income.

Some methods of income splitting allowed in Canada 1.Purchase a spousal RRSP. The higher-earning spouse can make an RRSP contribution in the lower-earning spouse's name. The contributing spouse would get the tax deduction, and when the RRSP is eventually withdrawn (provided the withdrawal doesn't occur until at least two years after the RRSP has been purchased), the income is taxed in the hands of the lower-income spouse.

2.Pay a wage to your spouse. This only works if you are self-employed or run a family business. Suppose Jill earns $20,000 of income from her school teaching job and her husband John has $90,000 of net income from his farming operation. Their combined tax bill is just over $25,000. Now, suppose that John can reduce his income by transferring $20,000 to Jill. So John pays Jill $20,000 in wages for her work on the farm. Now John has income of $70,000 and Jill has $40,000. Their combined tax bill is now about $23,000. Total savings from income-splitting: about $2,000.

3.Pension income splitting The newest method, as announced October 31, 2006, is to split eligible pension income earned 2007 and onward. The higher-earning spouse can deduct up to 50% of his/her eligible pension income, and include it in the income of the lower earning spouse. Suppose you earn $100,000 in 2007 and of this, $60,000 is eligible pension income. Now suppose your spouse earns $20,000 and of this, $5,000 is eligible pension income. Normally, your combined tax bill would be about $29,000. Under the new pension income-splitting rules, however, you could elect to allocate up to 50% ($30,000) of your pension income to your spouse. This would lower your taxes and raise your spouse's, but your overall combined tax bill would come to about $26,500. Total savings: about $2,500.

Pension Income Splitting: the Details As you can see, this new pension income splitting proposal offers great tax-saving opportunities to Canadian seniors. Anyone who earns eligible pension income can take advantage of this opportunity. What is "eligible" depends on your age. If you are age 65 or over, eligible pension income includes most income received from any registered pension plan (RPP), registered retirement savings plan (RRSP), or registered retirement income fund (RRIF). If you are under 65 years of age, eligible pension income is limited to most RPP income and other specific amounts you receive as a result of the death of your spouse.

The decision to split pension income will require some careful consideration. First, you will need to decide if income splitting is right for you. While it can save some couples thousands of dollars, it is certainly not the solution for everyone. In some cases, the benefits of splitting may not outweigh the losses in personal tax credits. Splitting pension income can eliminate the spousal, age, and medical tax credits to which you may otherwise have been entitled to. It can also impact the lower earning spouse's Old Age Security (OAS) entitlement and even cause a clawback of their OAS benefits. If you do decide to split pension income, you'll then need to determine the split that will give you the most tax savings. This may involve some detailed calculations, so you may want to enlist the help of your tax advisor. This decision, however, won't have to be made until 2008 when it's time to prepare your 2007 tax return.

Which income splitting method is best? Some couples may decide that this new pension splitting opportunity will eliminate the need to make spousal RRSP contributions. However, choosing an income splitting method is not always that simple. There are other issues to take into consideration, such as age, marital matters, and your level of earnings. Talking to a tax advisor can ensure you have weighed all of the factors surrounding each type of income splitting. You can contact Kevine at Kevin Keith would like to thank Julie Wushke of KPMG for her assistance with writing this article.