If You’re A Couple, You Should Split Up!
Updated: Sep 17, 2021
No, I am not talking about divorce! I am talking about income splitting. Income splitting is a strategy that has been around forever in Canada, is commonly underutilized, and if you are a couple it is a strategy you should definitely educate yourself on and build a plan towards! Income splitting allows you to transfer higher income-earning dollars to a lower income-earning spouse, in the ultimate effort of reducing your overall tax bill. There are income splitting strategies you can apply before retirement, but arguably, the majority of this benefit comes following retirement. And more importantly, how you set up your investments and your income pre-retirement will have an impact on your success splitting your income post-retirement. In some ways, the government helps you with this plan, by incentivizing programs like RRSPs, TFSAs, and RPPs. But in order for you to benefit, you need to purchase and maximize your contributions to these plans throughout your working life. If you do not start early, catchng up later is difficult (though not impossible). There are also some ways to split non-registered investment income that you may not be aware of.
RRSPs/RIFs (registered retirement savings plans & registered retirement income funds) - if you are saving money in excess of your TFSA contributions every year, you should arguably be putting money towards your RRSP room. Not only will these contributions reduce your tax bill by removing your RRSP contribution amount from your gross income in the year they are bought, they also have enormous potential to reduce your future taxes in retirement. You can split your income preretirement by setting up spousal RRSPs, which allows you to contribute to your spouses RRSP room, and have the future income taxed in their hands. This is particularily useful if you plan to retire before age 65, as RRSPs cannot be split for income unless converted to RIFs and you are 65 years old. Or, alternatively, if you do not want to convert to RIFs until required to at age 71, it gives you another option to split income. I’m an advocate for setting up your RIFs earlier rather than later if possible. An RRSP converted to RIF generates regular income for the holder, and at age 65 you can split this income with your partner. Income from a RIF also gives you access to the pension income credit of $2k per person. At any rate, spousal RRSPs at any age and RIFs at age 65 allow you to split income with spouses, so these are the ultimate considerations for your income splitting strategies.
TFSAs (tax-free savings accounts) - TFSAs are a no-brainer for all Canadian savers and investors. All gains inside a TFSA is sheltered from all tax, making them go-to and first choice for your investments. The money is always accessible, with no restrictions on withdrawals or tax implications. The TFSA room is ultimately your responsibility to track though. If you take money out you can replace it up to your lifetime allowance, but CRA will not track this for you. Overcontributions are subject to tax penalties. They are also a great place to shelter post-retirement savings if you have any cash or investments in non-registered (unsheltered-from-tax) accounts. Moving money over annually from unregistered (taxable) investments and using up both partners’ annual TFSA allowances ($6k each or $12k/yr total), will save you almost $2k/year in taxes on a go-forward annual basis. Using this strategy adds up over time. If you haven‘t been maximizing your TFSA room, and have free cash outside tax-sheltered accounts, you will want to strongly consider putting it into TFSAs and investing it.
RPPs (registered pension plans) - these are employer pension plans and may be either “defined contribution” or “defined benefit”. In both cases the employee is allowed to contribute an annual amount (generally 2% of gross income) and the employer matches it. With tenure employers will incrementally pay more towards your plans (generally 4-6%) providing you contribute the maximum. Defined contribution is basically a plan that you direct into investments during your working years, and will ultimately manage post-retirement, while defined benefit is a plan your employer’s benefit provider directs through your working years and manages for you post-retirement. Defined contribution plans place the value in your hands and pay out from a future LIF or Annuity that you have set up on your own with a provider to withdraw your funds, while defined benefit places the value in your group plan and pays out a fixed amount over your life managed by the employer‘s benefits provider. If you are fortunate enough to have a company pension plan, I recommend you use it and maximize it. You can generally increase the total contributions and the value of your plan through tenure and/or increasing your salary, as the contributions from you and your employer are a percentage of your salary. The beauty of RPPs is that there are no age limits on splitting this income. If you qualify to withdraw your pension, you qualify to split this income with your spouse. When you have converted to income bearing products e.g. LIFs, annuities, or start recieving payments from your company plans, you can split this income. This income also gives the income-bearer access to the pension credit of $2k per person.
Group RRSPs - group RRSPs are a play on a traditional pension plan, though they are still RRSPs. Contributions are allowed by employee and matched by employer in a tiered structure depending in tenure similar to RPPs. As they are considered personal RRSPs, the contributions from you and your employer go towards, and reduce, your annual alloted RRSP room. If you ever leave the company you can transfer the funds acccumulated in your group RRSP into your personal RRSP, unlock them in retirement under the normal RRSP rules, and income-split them at age 65 by normal RIF rules.
Non-registered Investments - you may get to a point where you are maximizing your RRSP and TFSA room, and still want to save and invest your money? You do this because you know it can earn much more here than in any bank account. You may have opened a taxable, non-registered investment account with your broker? If you have these types of non-registered accounts, they are taxed annually on the income generated from the dividends, and pay capital gains on any windfalls earned from cashing in shares. There are a few points to ponder with these types of accounts. Firstly, these are accounts where sovereign equity investments are highly favoured tax-wise. Secondly, any income or gains will be taxed in the account holders hands. Thirdly, if you suffer losses, they can be used to offset gains and carried forward to use later. Fourthly, these accounts can be used in a couple different ways to split income, both pre and post retirement. If you are not retired yet, having this account in the lower income earner’s name might make sense, to allow the income to be taxed in their hands. Or possibly have two accounts, one in each others’ names, with the goal of balancing the income to each partner in a way that makes sense towards balancing your annual tax bill. If you hold money in these unsheltered accounts when you retire, you may want to consider making them a joint account. This allows you to split income evenly and simplifies your estate plan by avoiding probate issues and/or tax complications for heirs.
Of course there are other potential sources of retirement income, e.g. rental property income, which are common sources of income for Canadians. This income is also splittable if you are co-owners. It may be 50/50 or some other denomination adding to 100%. I have no experience with rental strategies in retirement, but knowing how to manage and split this income, if you have it, is also important to your retirement plans. Personally, I prefer REITs (Real Estate Investment Trusts) to owning single rental property/s. They have all the benefits of owning and renting without the hassle of administration, maintenance, renter issues, and exposure to a single market (house) or location. REITs also have the power of diversity.
There are a couple more strategies you can use, but these are the more common ones leading into, and in, retirement. Knowing your income splitting options allow you to plan and execute a tax-efficient decumulation of your money.