Pension income splitting can be a powerful tool for retirees to optimize their tax burden, increase government benefits, and achieve financial equilibrium in retirement. By transferring income from one spouse to another, couples can lower their combined tax bill and take advantage of income tax credits. Here’s a comprehensive guide to the types of pensions you can split and how to leverage this strategy effectively.
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What is Pension Income Splitting?
Pension income splitting allows individuals to transfer up to 50% of eligible pension income to their spouse or common-law partner for tax purposes. This strategy can significantly reduce the overall taxes paid by couples where one partner earns more retirement income than the other.
Eligible Pension Income Sources
Defined Benefit (DB) Pension Income
DB pensions, often provided by employers, are calculated using a formula that includes years of service and salary. Payments from these pensions are eligible for income splitting if the recipient is over 55. By moving up to 50% of this income to the lower-earning spouse, couples can enjoy potential tax savings and improved government benefits.
Supplemental Executive Retirement Plans (SERPs)
SERPs, designed for executives, include both registered and unregistered portions. While the registered portion qualifies for income splitting, the unregistered portion must be reported by the recipient. Details are usually outlined in government-issued tax slips.
Registered Retirement Income Funds (RRIFs)
Withdrawals from a RRIF are eligible for income splitting once the account holder reaches age 65. Consider converting a Registered Retirement Savings Plan (RRSP) to a RRIF early to take advantage of this rule, especially if it aligns with your broader decumulation strategy.
Foreign Pensions
Most foreign pension income, including payments from U.S. 401(k) accounts, is eligible for income splitting if it is taxable in Canada. However, distributions from U.S. Individual Retirement Accounts (IRAs) do not qualify.
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Non-Eligible Income Sources
Canada Pension Plan (CPP) and Old Age Security (OAS)
CPP and OAS payments cannot be split through the typical income-splitting mechanism. However, CPP offers a pension-sharing option. By applying through Service Canada, spouses can redistribute CPP contributions earned during their relationship, potentially balancing retirement income and reducing taxes.
RRSP Withdrawals
Withdrawals directly from an RRSP are not eligible for income splitting unless converted into a RRIF or annuity.
Income Splitting for Business Owners
Business owners aged 65 and older can split income by paying dividends to their spouse without triggering the Tax on Split Income (TOSI) rules. This allows for effective income splitting using corporate savings or income, which can act as a self-managed pension.
Key Strategies to Maximize Benefits
1. Use a Spousal RRSP
Higher-income spouses can contribute to a spousal RRSP, allowing the lower-income spouse to withdraw funds in retirement at their lower tax rate. Be mindful of the three-year attribution rule to avoid penalties.
2. Consider Early RRSP Conversion
If you plan to retire before age 71, converting part of your RRSP to a RRIF by age 64 can allow you to start splitting income at age 65.
3. Plan for CPP Pension Sharing
Evaluate whether CPP sharing will provide a net benefit based on your future income projections.
4. Annual Tax Review
Each year, assess your combined income to determine the optimal amount to split. Changes in income levels, tax brackets, and government benefits may influence the decision.
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The Bottom Line
Pension income splitting is a valuable strategy for reducing taxes, increasing retirement cash flow, and ensuring financial equity between spouses. By understanding eligible income sources and planning strategically, couples can maximize their retirement benefits and secure a financially stable future. Always consult a tax professional or financial advisor to tailor these strategies to your unique circumstances.
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