Pension Income Splitting

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1 Pension Income Splitting And Other Recently Announced Changes for Retirees New tax rules were recently introduced by the federal government that will allow senior couples to split their pension incomes in order to reduce overall taxes paid, beginning on 2007 income tax returns. This article outlines the details of how this and other changes to tax rules for seniors might benefit you and your spouse in coming years.

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3 The federal government recently announced its self-described Tax Fairness Plan that introduced the concept of pension income splitting for couples. The announcement of the new tax measures heralded the ability for Canadian seniors to split their pension incomes when they file their 2007 income tax returns, which will offer varying degrees of tax relief for pensioners. Essentially, the basic idea behind pension income-splitting is that if you earn income eligible for the pension income tax credit (see box below for information on what is included), you and your spouse or common-law partner may be able to reduce your combined tax bill by allocating to the lower income-earner up to 50% of the higher income-earner s eligible pension. Pension income splitting will benefit many senior couples with disparate pension incomes. Due to Canada s progressive tax system (the more income you earn, the higher your marginal tax rate), the spouse who receives a pension likely pays much more tax than the spouse who has little or no pension income. In the case of most couples, however, the pension income is used to support both partners. So, by having the ability to split the pension income between both individuals tax returns, the overall tax paid may be greatly reduced (assuming the lower earner pays tax at a lower marginal rate). Pension income eligible for splitting If you are 65 years of age or older, the major types of eligible pension income are: Lifetime annuity payments under a registered pension plan (RPP) Payments out of or under a registered retirement income fund (RRIF) or a locked-in RRIF Lifetime annuity payments under a registered retirement savings plan (RRSP) Payments from an individual pension plan (IPP) Income from a deferred profit sharing plan annuity (DPSP) If you are under 65 years of age, the major types of eligible pension income are: Lifetime annuity payments under a registered pension plan (RPP) Payments from a RRIF, or annuity payments from an RRSP or from a DPSP received as the result of the death of a spouse or common-law partner Payments from an individual pension plan (IPP) Income that is not eligible includes: Old Age Security (OAS) Guaranteed Income Supplement (GIS) Canada Pension Plan / Quebec Pension Plan (although existing CPP/QPP splitting will remain) RRSP withdrawals Income from retirement compensation arrangements (RCAs) Phillips, Hager & North Investment Management 1

4 How you and your partner can benefit from pension income-splitting The basic rules of pension splitting are reasonably straightforward. If you are the higherearning spouse, you can allocate up to half of your eligible pension income (see box on page 1) to your lower-earning spouse or partner by deducting it from your declared net income on your tax return. Your spouse, in turn, adds the deducted amount as reported pension income on his or her tax return. This decision does not commit you to repeat the process in the future. Each year, both you and your spouse must decide together whether to split pension income, then agree upon the amount to be allocated on your individual tax returns for that year. Each year you file your income tax returns, you will need to review your respective incomes and determine the amount to be split. This will be influenced by the amount of income you each make, your financial planning decisions and investment strategies. It will also be important to consider the impact of the additional pension income on the tax situation of the lower-earning spouse or partner. Increasing his or her taxable income may have an effect on the amount of personal tax credits that could either be claimed or transferred to the higher earner. In addition, increasing pension income could affect the lower-earning spouse s Old Age Security (OAS) entitlements. It could also trigger the requirement for the lower-earning spouse to pay tax by installments. The box on page 4 outlines the steps to follow to determine how to split your pension income with your spouse for best advantage. Due to the possible domino effect pension splitting may have on your overall tax situation, we recommend consulting an accountant or other financial professional to assist you in determining the optimal way for you and your spouse to take advantage of the new rules. Additional tax changes designed to benefit seniors Pension income splitting is one of a number of new tax measures designed to benefit seniors in Canada. Other changes include increases to the pension income credit, enhancement to the age credit, and an increase to the age limit for converting registered retirement savings plans (RRSPs) to registered retirement income funds (RRIFs). Phillips, Hager & North Investment Managemen 2

5 Pension income credit* * Effective 2006, you can claim a credit on the first $2,000 (increased from $1,000) of eligible pension or annuity income (see box on page 1) you report when you file your income taxes. Age credit* The federal age credit is intended to help middle- and lower-income seniors. The amount on which the age credit is calculated has been increased to $5,066 from $4,066, retroactive to January 1, 2006, which will provide up to $155 of additional federal income tax relief each year for eligible seniors. The credit is based on annual income; it begins to be phased out when net income reaches $30,270 and is fully phased out when net income reaches $64,043 (these values are indexed to the Consumer Price Index). Any unused portion can be transferred to your spouse or partner and claimed on his or her income tax return. Old Age Security limits and clawback Pension income splitting may help higher-income earners who are affected by the Old Age Security (OAS) clawback to gain access to additional retirement funds. The OAS clawback is an issue for the small percentage of Canadian seniors who exceed the maximum income amounts for OAS eligibility. These individuals may be able to transfer a portion of their pension income to a lower-earning spouse to bring themselves within eligibility levels. The maximum OAS benefit for 2007 is $5,903. The clawback for 2007 begins on net annual income greater than $63,511, and OAS is fully eliminated when net income reaches $102,865. This means that if your net income exceeds $63,511, taking advantage of the new pension income splitting provisions could make you eligible for OAS benefits that would otherwise be clawed back. RRSP and RRIF age limits The maximum age limit for converting an RRSP to a RRIF has been raised from 69 to 71. This change gives individuals an additional two years to contribute to their RRSPs (to the extent that they have contribution room available) and enables individuals to defer the payment of tax for two additional years. Individuals who fall within the transitional ages of 69 to 71 in 2007 may wish to contact a financial advisor to review their options. * Quebec offers similar tax credits for pension income, and for individuals who are 65 years of age and older. Phillips, Hager & North Investment Management 3

6 Possible tax savings from pension income splitting As everyone s financial situation is different, the recently announced tax measures will provide different levels of benefit for different couples. Consider, for example, the following hypothetical couple: Each spouse is 65 years old, receives Canada Pension Plan (CPP) benefits, which they have elected to split, and also receives OAS. The husband receives $75,000 in eligible pension income (i.e., from a registered pension plan or income from a RIF) and the wife earns $10,000 in interest and taxable capital gains. By jointly electing to report $32,500 of the husband s pension income on the wife s return and therefore making their incomes equal, the couple is able to pay a reduced total amount of taxes and take greater advantage of the age and pension credit. The husband also gains access to some OAS benefits that otherwise would have been clawed back. The new tax measures help the couple save between $3,600 and $4,700 on their family tax bill, depending on their province of residence. Steps to splitting your pension income 1. Calculate the amount of eligible pension income that each partner earned in Determine the impact of allocating different amounts of income from the higherearning spouse to the lower-earning spouse on the tax returns of each. 3. Decide the amount that will be allocated (up to 50% of eligible income) from the higher-earning spouse to the lower-earning spouse. 4. Reduce the amount on the income statement of the higher-earning spouse s tax return by the agreed-upon amount. 5. Include the same amount in the income statement on the lower-earning spouse s tax return. 6. Using the same percentage, allocate any income tax withheld at source to the lowerearning spouse s tax return. 7. Since reallocating pension income may increase the lower earning spouse s tax payable, both individuals must jointly agree to this allocation by making that election in each individual s tax return every year. 8. Consult with your accountant or financial advisor on the best way to maximize the opportunities available through the new tax rules. There may be options that your financial advisor could propose that will provide you with better results than you could ascertain on your own. Phillips, Hager & North Investment Managemen 4

7 Are spousal RRSPs still relevant? Spousal RRSPs are those to which one spouse has contributed, with the other spouse being the owner and the eventual recipient of taxable withdrawals from the plan. Spousal RRSPs are often used both to allow the higher-earning spouse to receive the tax deduction benefit during the contribution period, and for income-splitting purposes after retirement since the amount withdrawn is counted toward the income of the other spouse, and often taxed at a lower marginal rate. However, now that pension-splitting is an option for retired couples, the question is, do spousal RRSPs remain a useful tool? The short answer is yes. Spousal RRSPs have a role to play in many financial plans: however, they may be less attractive for certain investors. Because the new pensionsplitting option is not available for people under 65 with respect to RRSP withdrawals, a spousal RRSP may still be worthwhile for people planning to retire before age 65. It may also help younger couples save money for a down payment on a first home. By accumulating money in a spousal RRSP, the couple may benefit from the withdrawal rules under the Home Buyers Plan. Planning ahead If you are retired or planning to be soon, we recommend that you consult your financial advisor as soon as possible to determine the best way to take advantage of the new tax rules. If you have questions or would like to speak with one of our investment professionals, please call our Investment Funds Centre at Phillips, Hager & North Investment Management 5

8 Phillips Hager & North Investment Management is an operating division of RBC Global Asset Management Inc. (RBC GAM), an indirect, wholly-owned subsidiary of Royal Bank of Canada. RBC GAM is the manager and principal portfolio advisor of the PH&N Funds and the principal distributor of the Series O units of the Funds. PH&N and Phillips, Hager & North are registered trademarks of Royal Bank of Canada. Used under licence. Copyright RBC Global Asset Management Inc., Publication date: August 30, 2007

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