What does pension splitting have to do with RRSP season?

In our blog, “Will I have too much money?”, posted earlier this month, we discussed how registered retirement savings can be strategically used to reduce the tax burden after death. As we near the end of the 2020 RRSP season, it makes sense to touch on one way registered retirement savings can help ease the tax burden in retirement.

Pension income splitting – introduced to Canada in 2007 [1] – allows a person to claim a portion of their partner’s pension when they file their taxes. By doing so, the higher-earning spouse has an opportunity to lower their taxable income on their personal return without reducing cash flow to the household.

To understand how this works, we need to understand marginal tax: the tax rate applied to the next dollar earned. The combined provincial (Manitoba and Saskatchewan) and federal marginal tax rates for 2020 are as follows:

The larger the income difference between partners, the more beneficial income splitting tends to be. Let’s say a Manitoba couple is considering pension income splitting for the 2020 tax year. Partner 1 has a retirement income of $85,000 and $50,000 of this is pension income. Partner 2 has $33,500 total annual income. Without income splitting, each spouse would fall into the following tax brackets:

Partner 1: $85,000 income has a marginal tax rate of 37.90%

Partner 2: $33,500 income has a marginal tax rate of 27.75%

Now, if Partner 2 were to claim $15,000 of Partner 1’s pension income on their tax return, each spouse would then fall into the following tax brackets:

Partner 1: $70,000 income has a marginal tax rate of 33.25%

Partner 2: $48,500 income has a marginal tax rate of 27.75%

When the couple files their taxes, each partner fills out a T1032 form. Partner 1 indicates they are making the transfer; Partner 2 indicates they are receiving the transfer and they both specify how much that transfer is worth. The couple must opt-in to income splitting on a yearly basis, meaning they always have the flexibility to do what makes the most financial sense for their current situation. 

The couple may decide to forgo income splitting one year if they, for whatever reason, end up in the same marginal tax bracket. Seeking advice from a professional who specializes in tax planning is the best way to determine whether income splitting is right for you each year.

An advisor may recommend income splitting to a couple even in situations where it may not seem necessary or beneficial (i.e., having drastically different retirement incomes). Income splitting can make a lot of sense in situations where, for example, one spouse is not eligible to receive the pension income tax credit because they don’t have qualifying pension income.

The pension income tax credit is available to people 55 or older and “it enables you to deduct, from taxes payable, a tax credit equal to the lesser of your pension income or $2,000. Depending on which province you live in, this equates to $440-$720 in actual tax savings each year.”[2] If one partner derived all their retirement income from rental income and thus didn’t have any qualifying pension income, income splitting could make them eligible to receive the pension income tax credit.

Pension income splitting is just one of many types of income splitting strategies. Other situations where it is applicable include:

• Sharing your CPP retirement pension with a spouse
• Transferring dividend income to a spouse
• Transferring capital losses to a spouse
• Spousal RRSPs and RRIFs
• Lending money to your spouse or child
• Filing tax returns when you have a spouse
  • Claiming tax credits and deductions with a spouse
  • Reporting/allocating investment income earned in a joint account
• Splitting income by employing your spouse or child
• Having the lower income spouse invest all earnings[3]

What makes sense for one couple may not make sense for another so seeking professional advice about income splitting is always recommended.

Contributing regularly to an RRSP (or other savings account) is an excellent way to ensure our – and potentially a loved one’s – financial future. Even if income splitting, pension or otherwise, isn’t a priority right now, knowing about different strategies for making the most of your (retirement) income is always a good idea.

For advice on income splitting strategies, or for help with making a last minute, 2020 RRSP contribution, connect with us.

[1] https://irpp.org/research-studies/income-splitting-and-joint-taxation-of-couples/

[2] https://retirehappy.ca/are-you-taking-advantage-of-the-pension/#:~:text=The%20Pension%20Income%20Tax%20credit%20is%20available%20to%20you%20if,actual%20tax%20savings%20each%20year

[3] https://www.taxtips.ca/personaltax/incomesplitting.htm