Pension income splitting offers benefits beyond making the best use of each spouse’s graduated tax rates.Ja_inter/iStockPhoto / Getty Images
This article is part of a new Globe Advisor series, Pensions Unpacked, exploring how workplace pensions fit into retirement strategies, and the technical details and decisions that come with the plans.
One of the more powerful tax-planning opportunities available to older clients is splitting pension income with a spouse or a common-law partner.
Under the Income Tax Act, an individual is allowed to allocate up to 50 per cent of their eligible pension income to their spouse, lowering their combined tax liability.
How it works
To split pension income, both spouses must file a joint election on their tax returns using Form T1032. The transferring spouse claims a deduction for the split-pension amount on their tax return while the receiving spouse adds the amount to income on their return.
Only certain sources of retirement income are eligible for pension income splitting. These include:
- annuity-type payments from a registered pension plan;
- payments from a registered retirement income fund (RRIF) or life income fund (LIF); and
- certain payments from foreign pensions, including U.S. 401(k) plans.
Age and other restrictions
A couple can split pension income from a registered pension plan at any age. However, the transferring spouse must be at least 65 years old to split payments from a RRIF or LIF with their spouse, who can be any age. (Quebec doesn’t allow those under 65 to split any type of pension income for provincial tax purposes.)
Withdrawals from a registered retirement savings plan (RRSP), and Canada Pension Plan (CPP), Quebec Pension Plan (QPP) and Old Age Security (OAS) payments, aren’t eligible for pension income splitting. (However, couples may be able to share CPP or QPP to achieve income splitting.)
Payments from supplemental executive retirement plans and U.S. individual retirement accounts (IRAs) also aren’t eligible.
Managing 401(k)s
Canadians considering transferring a U.S. 401(k) to an IRA, perhaps to access a broader range of investment options, should factor in that payments from an IRA aren’t eligible for pension income splitting while payments from a 401(k) plan are, says Jason Heath, managing partner at Objective Financial Partners in Markham, Ont.
For a client with a large 401(k), the opportunity to split pension income “might support leaving [it] intact,” he says.
Avoiding OAS clawback
Pension income splitting offers benefits beyond making the best use of each spouse’s graduated tax rates.
By allocating income to a lower-income spouse, a higher-income spouse may be able to mitigate or eliminate OAS clawback. On the other hand, care must be taken that allocating income to a lower-income spouse doesn’t expose them to OAS clawback.
“Commercial tax software has optimizers where it’ll run a bunch of different iterations to try to figure out the ideal amount to split,” Mr. Heath says.
RRIF planning
Where a high-income spouse has a large RRIF (or a large RRSP, part or all of which can be converted to a RRIF), it might make sense to withdraw more than the mandated annual RRIF minimum to split pension income with a lower-income spouse.
“Sometimes I see [taxpayers] who are 65 years old with very little income, and they’re going to have a very significant income in their 70s because they have a large RRSP, or they’re deferring CPP or OAS,” Mr. Heath says.
In those circumstances, “it can really make sense to convert an RRSP to a RRIF and take large withdrawals to use up both spouses’ low tax brackets,” he says.
Pension income tax credit
Even couples in the same tax bracket may benefit from pension income splitting. That’s because allocating up to $2,000 in eligible pension income to a spouse who is receiving little or no pension income can ensure both spouses can access a $2,000 pension income tax credit.
Taxpayers can claim a non-refundable credit of 15 per cent federally for up to $2,000 of eligible pension income. There are also provincial and territorial pension income tax credits.
Taxpayers 65 and over can claim the pension income tax credit on any eligible pension income. However, those under 65, including those who receive split pension income, can claim the credit only for certain types of pension income, such as the life annuity payment from a pension or annuity payments received due to the death of a spouse.
CPP, QPP, OAS payments and RRSP withdrawals aren’t eligible for the pension income credit.
Those 65 and older who are still working (or otherwise not receiving pension income) might consider converting part of their RRSP to a RRIF anyway to take advantage of the pension income credit both for themselves and for their spouse – and, potentially, to split pension income, says Tim Brisibe, vice-president of tax and estate planning with Mackenzie Investments in Calgary.
“You’re not forced into retirement at 65, but you can take advantage of some of these [pension-related] planning opportunities,” he says.