Finding The Right Split

FORUM Magazine


Buried in the controversy of last year's federal government decision to tax income trusts were provisions allowing for splitting of pension income. As Jamie Golombek points out, the changed rules may usher in a new era of "retirement math" for advisors to consider.

While 2007 has brought with it many tax changes announced by the federal government, perhaps the most significant for advisors and their clients is the ability to split pension income.

This change, unveiled October 31, 2006, was perhaps lost on some of your irate senior clients who were too upset at the government's other announcement that day - the decision to begin taxing income trusts - to notice they've been handed a whole new opportunity to save taxes going forward. For many, the rules of "retirement math" may have changed in a significant fashion.

How it works

Beginning this year, the rules state that any Canadian resident who receives income that qualifies for the existing pension income tax credit will be permitted to allocate to his or her resident spouse or common-law partner any amount up to one-half of that income.

Note that no physical splitting is required. It is simply a notional split that is accomplished by electing in each spouse's or partner's 2007 tax return the amount that is desired to be deducted from the person that actually received the pension income and included in the income of his or her spouse or partner.

Naturally, since the pension income being transferred will increase the transferee's own tax payable, both spouses or partners must specifically agree to the allocation in their tax returns for 2007. (Both the agreement and amount can be changed from year to year.)

The government has specifically stated that the pension income transferred will indeed retain its character in the hands of the transferee spouse or partner for all purposes. This has two specific benefits, to be discussed in more detail below: the ability for each spouse to now claim the newly doubled $2,000 pension income credit and the potential ability to avoid Old Age Security clawbacks for some higher-income pensioners.

What income qualifies?

The rules governing the type of pension income that will qualify for income splitting mirror exactly the rules governing eligibility for the $2,000 pension income credit, but are so confusing, they're worth reviewing again.

For clients aged 65 years and older, the main types of qualifying pension income that can be transferred to a spouse's or common law partner's return are:

pension income from a defined benefit or defined contribution registered pension plan (DB or DC RPP) ;
income from a registered retirement savings plan (RRSP), as long as it has first been converted to an annuity; and
registered retirement income fund (RRIF) withdrawals (including LIFs).

For clients under age 65, the list is far more restrictive basically only including income from a DB or DC pension plan.

Some types of income that specifically do not qualify for splitting include:

Old Age Security (OAS);
Guaranteed Income Supplement (GIS);
Canada Pension Plan (CPP)/Quebec Pension Plan (QPP) (see below);
RRSP withdrawals (non-annuity); and
income from retirement compensation arrangements (RCAs).

Note that while technically CPP income doesn't qualify for the new pension splitting rules, spouses and common-law partners, who are both at least 60 years of age, can already share up to half their CPP retirement benefit. The split is based on the number of years the couple lived together during the period they were required to contribute to CPP.

Age discrimination

Perhaps the biggest inconsistency expressed by many commentators in the three months since the rules have been announced is the apparent age discrimination between RPP members who can split their pension income at any age as opposed to RRSP pensioners, who are forced to wait until age 65 to split their pension income.

Responding to the age 65 requirement for RRSP annuity, RRIF and LIF income, the government reiterated that the purpose was to "target the pension income credit to retired individuals". It explained that since individuals have much greater personal control over the timing of withdrawals under RRSPs, RRIFs and LIFs compared to RPPs, without the age 65 eligibility rule, many individuals who are not retired could gain significant tax advantages well before they attain age 65 by arranging to withdraw money each year as RRSP annuity or RRIF income while still saving for retirement. Individuals receiving RPP income, on the other hand, generally have little control over the timing of their pension payments since they usually only receive such payments when they are retired.

That being said, one could easily envisage a situation where someone in a DB RPP decides to take "early retirement" at age 55 for the sole purpose of splitting his pension income with a non-working spouse and then immediately recommences employment with a new employer.

An RRSP contributor could not do likewise as she must wait until 65 to split her income with the result that she is being discriminated against, both on account of her age and the type of retirement vehicle in which she has participated.

At the time of writing, the Investment Funds Institute of Canada (IFIC) Tax Working Group was in the process of drafting a submission to the Department of Finance asking for this discrimination to be removed from the final legislation before it is formally presented this winter in the House of Commons.

Note that if this age discrimination continues and is not removed from the final legislation, it will provide one of the main incentives for non-RPP members to continue to contribute to spousal RRSPs, as they will still provide a formal avenue for pension income splitting before age 65 as appropriate.

Planning opportunities

While the decision to allocate qualifying pension income to a spouse or partner for this year needs not be made until the 2007 tax returns are filed in April 2008, it is never to soon to start planning. Advisors should identify opportunities to ensure clients can maximize the benefits of income splitting by adjusting their income, where possible, to take into account the new retirement math. A number of specific areas come to mind.

Doubling up of the pension credit

Presumably, nearly all married or common-law pensioners would be encouraged to pension split at least $2,000 of qualifying income so that each spouse or partner will be entitled to his or her own pension credit. This will be of interest where only one spouse or partner has pension income and the other does not.

OAS clawback planning

While approximately 97 per cent of eligible seniors get full OAS benefits and less than one per cent are fully clawed back, the new pension splitting regime will permit us to help that vocal three per cent minority who are indeed affected by the clawbacks.

For 2007, the maximum OAS benefit of $5,954 begins to be clawed back at a rate of 15 per cent on net income above $63,511. For clients whose pension income puts them into clawback territory, the ability to shift some pension income to a lower-income spouse or partner to avoid the clawback is a significant opportunity - even if the client's spouse or partner is in the same tax bracket and thus no tax savings would typically result.

For example, let's assume that Jack and Dianne both fall into the second 2007 federal bracket (22 per cent), which spans income from $37,178 to $74,357. If Jack's qualifying pension income is $10,000 and his total net income was $70,000 while Dianne's income was about $55,000, if Jack were to elect to allocate half of his pension income or $5,000 to Dianne, he would protect $750 (15 per cent x $5,000) of his OAS from the clawback.

Age credit planning

The age credit, available to Canadians 65 years of age and older, may be another area where prudent pension splitting planning may assist your client. For 2007, the age credit is $5,177, which is phased out at 15 per cent beginning at net income of $30,936. The full phase-out for 2007 would occur when net income reaches $65,549.

This planning may be helpful where one client spouse is over 65 and subject to the age credit clawback whereas her husband is under 65 and ineligible for the credit. By shifting pension income to her husband, she may not only protect some OAS (as discussed above) but also protect part of her age credit.

Spousal loans

Traditional financial planning has often turned to spousal loans extended at the CRA's prescribed rate to legally split investment income between spouses or partners. With the high prescribed rate (it stands at five per cent this quarter) coupled with the new ability to income split pension income, you may wish to reconsider establishing new spousal loans for clients if there may be a pension income splitting opportunity instead.

Capital gains realization

Have clients living on a pension with significant unrealized capital gains in their portfolios? Perhaps the new pension splitting rules will finally afford your pension clients the opportunity to realize that gain and rebalance their portfolio without putting themselves into a higher bracket, losing some OAS or having their age credit reduced.

A new planning frontier

The above are just a few planning tips to think
about in light of the new, substantial tax planning opportunity for seniors. And this is just scratching the surface. There will likely be many more planning ideas for advisors to consider in reducing the total tax burden of their pensioner clients in light of the new retirement math.