Understanding pension splitting rules
New pension splitting rules were introduced in Canada in 2007 and in my opinion, it was one of the most significant tax breaks given to retired couples.
Income splitting is a great strategy to reduce taxes if you can move income from a higher income earner to a lower income earner. An individual who makes $80,000 per year would pay considerably more tax than a couple that earned $40,000 each. There are three common income splitting strategies available for retirees:
What is pension splitting?
Pension splitting allows a spouse to give up to 50% of their eligible pension income to their spouse for tax purposes only. There is no need to cut a cheque or give cash. Pension splitting is a paper transfer done via the tax returns.
What is eligible pension income?
The most common form of “eligible” pension income is income from a registered company pension plan whether it is a defined benefit pension or defined contribution pension.
For those people who did not have a registered pension plan through work, they can take advantage of pension splitting by converting their RRSPs or deferred profit sharing plans into income through a life annuity or a RRIF. Unfortunately, those individuals that do not have a registered pension plan, have to wait until after the age of 65 to split their pensions.
Who should take advantage of pension splitting?
There are three conditions to pension splitting:
- You must be married or in a common-law partnership with each other in the year. (You cannot be living apart for more than 90 days because of marriage breakdown).
- You were both resident in Canada on December 31 of the year
- You received eligible pension income
The general rule of thumb that I use to see if pension splitting makes sense goes something like this:
If the pension earner is in a higher marginal tax bracket than the spouse, then it makes sense to move money from a higher tax bracket to a lower tax bracket.
Three examples where pension splitting makes sense
One pension household:Rick is 66, self employed and still working. His wife Susan has retired at age 60 with a $1200 per month pension plus $325 per month from Canada Pension Plan.
Although Susan can give up to $7200 to Rick under pension splitting, she should no because Susan is in a 25% marginal tax rate and Rick is in a 36% marginal tax rate.
Since Rick does not have a pension, Susan can give Rick $2000 of her pension so that he qualified for the $2000 Pension Income Tax Credit. Alternatively, Rick can also convert some of his RRSPs to a RRIF or an annuity to generate $2000 per year of income which would also make him eligible for the Pension Income Tax Credit.
One couple with two pensions:Joanne and Steve are both retired teachers. Steve has a bigger pension ($2800 per month) and continues to do some contract work on a part time basis. When Steve adds up his income (Pension, CPP, and part time work), he is making about $65,000 per year and is in the 32% marginal tax bracket. Joanne is making about $1900 per month from pension and $450 per month from CPP. At $28,200 of income, Joanne is in the 25% marginal tax bracket.
Under the pension splitting rules, Joanne and Steve can give their spouse up to 50% of their pension for tax purposes. It makes no sense for Joanne to move money from a lower tax rate to a higher tax rate. It does, however, make sense for Steve to give some of his pension to Joanne. If the next tax bracket is $42,707, then Steve can give Joanne $14,507 of his pension ($42,707 minus $28,200). This moves money from a 32% tax bracket to a 25% bracket and saves them $1015 in taxes. Steve is eligible to move up to $16,800 to Joanne but anything greater than $14,507 puts her into the 32% marginal tax rate.
Common law with no pensions: Zack is retiring at the age of 62 and never had a pension through work. Instead, he contributed to a group RRSP and when he retires he figures he will need to generate about $2000 per month from a RRIF to supplement his CPP and some part time work he has lined up. His wife Miranda did not work much and also has no pension. She is currently collecting about $375 per month in CPP and does some freelance writing for about $500 per month.
Although Zack is in a higher tax bracket than Miranda, he cannot give any of his RRIF income to Miranda under pension splitting until the age of 65 because RRIF and annuity income does not qualify as eligible pension income until age 65.
Taking advantage of the pension income tax credit
The Pension Income Tax credit is available to you if you are 55 years of age or older. Basically, it enables you to deduct, from taxes payable, a tax credit equal to the lesser of your pension income or $2,000.00.
If a spouse does not have pension income, the spouse with the pension should give the spouse without a pension a minimum of $2000 of pension income through income splitting so that the spouse can qualify for the pension income tax credit. This effectively means the pension earner can get $4000 out of the pension without tax.
In the case of a two pension household where both spouses have pensions, they can’t each give the other $2000 to get $4000 of pension tax credits. There is a limit of $2000 per person.
Having pension income does not automatically qualify you for the $2000 pension income tax credit. You must claim the credit on line 314 of your tax return.
The paperwork for pension splitting
In order to take advantage of pension splitting, you have to complete Form T1032 – Joint Election to Split Pension Income.
Both spouses must sign the form. It’s a pretty simple process so make sure you take a look to see if pension splitting will save you some tax.
To get a full scoop on the administrative issues around pension income splitting, visit the CRA website.