A Spousal RRSP is an account that is used for future income splitting purposes. If you are a regular reader of this blog, you will know that it makes great sense to equalize income between spouses in order to reduce household taxes as much as possible – this is due to our progressive tax bracket system.
The lack of use of spousal RRSP’s is one of most overlooked financial planning strategies I encounter on a regular basis – and it is almost imperative that you set one up if your current planning strategies do not allow for equal income in retirement between spouses. (If you are wondering about the new pension income splitting rules – don’t worry, it still makes sense to set up spousal RRSP accounts and I’ll explain why in a post in the next few days.)
WHAT IS A SPOUSAL RRSP?
A Spousal RRSP account is an RRSP account that a higher tax bracket spouse (the contributor) deposits funds to, but once deposited, the funds belong to the annuitant (your spouse or common law partner who is currently in a lower tax bracket). The contributor claims the income deduction now, but withdrawals are taxed in the hands of the annuitant (except in a few particular situations outlined below).
WHY WOULD YOU USE A SPOUSAL RRSP?
The short answer is that it provides for a mechanism to equalize retirement income down the road. If you are both claiming an equal amount of income in retirement, you are almost certainly paying the least amount of taxes as a household unit as possible.
EXAMPLE OF INCOME SPLITTING
If one person had a gross income of $100,000 in 2007 they would pay about $28,961 in income tax (Ontario). If that income were split between two spouses with each having a gross income of $50,000 – then each are paying $9,915 per year in income taxes for a grand total of $19,830.
Hmmm… $28,961 in tax vs $19,830 in tax… That is a difference of almost $10,000! Multiply that by a 30 year retirement and you are looking at $300,000 in taxes that didn’t have to be paid. So you can see, it is not a subject to be taken lightly.
WHAT IS THE DIFFERENCE BETWEEN A CONTRIBUTOR AND AN ANNUITANT?
Contributor: The person making the contribution of funds to the spousal RRSP account (the higher income spouse).
Annuitant: The person who owns the spousal RRSP (the lower income earning spouse). Withdrawals from the account are taxed in their hands (except in certain situations as noted below under the Three Year Rule).
Generally speaking, if you have one spouse in a higher tax bracket during the working phase of life they would make a contribution to their spouse’s spousal RRSP account if it was necessary to allow for income equalization in the future. In other words, it is not necessary to set up a spousal RRSP account just because two spouses are in different tax brackets. For example, it is possible that a higher earning spouse has no pension, but the lower income spouse has a great pension. In this case, it might be better for the higher income spouse to just contribute to their own RRSP so that their RRSP/RRIF income will be approximately equivalent to the other spouse’s defined benefit pension income. Remember: the goal is income equalization.
The reason you use spousal RRSP accounts is so that the contributor to the spousal RRSP would claim the contribution as an income deduction on their own taxes (being in a higher tax bracket) and at the same time allow for the lower income earning spouse to build up their retirement income for the future. If the lower income earning spouse just contributed to their own account, the tax refund would be less even though the contribution would be the same.
It makes no difference to the contributor as to which account they contribute to from an immediate tax refund point of view. No matter how they allocate their contributions, the amount of tax relief they generate is the same if they made their contribution to their own RRSP or to a spousal RRSP or any combination in-between.
The contributor is limited to how much they can contribute to RRSP’s (their own or spousal RRSP’s) according to the same rules as usual. So, if they had $5,000 in RRSP contribution room they could elect to: A) Contribute $5,000 to their own RRSP; B) Contribute $5,000 to a spousal RRSP; C) Contribute $2,500 to their own RRSP AND $2,500 to a spousal RRSP; D) Any combination of contributions to both accounts so long as the total RRSP contribution made is within their limit. In other words, there is no extra RRSP contribution room allowed for making a spousal RRSP contribution.
THE THREE YEAR RULE
Any withdrawals from a spousal RRSP account are taxed in the hands of the annuitant BUT THERE ARE SOME EXCEPTIONS TO THIS RULE. The Three Year Rule states that contributions that are subsequently withdrawn during the same calendar year, or the following TWO calendar years, are taxable in the hands of the CONTRIBUTOR. This rule was designed to ensure that a high income earner would not set up a spousal RRSP account solely for the purpose of reducing taxes now by making the contribution (and claiming the deduction) and then withdrawing the money immediately from the spousal RRSP in the lower tax bracket annuitant’s hands.
Also, even though the contributor can claim a deduction for making a spousal RRSP contribution in the first 60 days of the following tax year, note that the Three Year Rule applies for the calendar year you make the contribution, NOT the tax year you claim the deduction. In other words, if you made a spousal RRSP contribution on Dec 31st, 2007 you could indeed withdraw the money and have it taxed in the lower tax bracket annuitant’s hands if you wait until Jan 1st, 2010. BUT, if you waited one more day to make the contribution on January 1st of 2008, even though you could still claim the deduction for the 2007 tax year, you could not claim the withdrawal in the lower tax bracket annuitant’s hands until January 1st, 2011.
EXCEPTIONS TO THE THREE YEAR RULE
Their are some exceptions to the three year rule:
1. The money is transferred into an annuity.
2. Spouses are living apart due to a breakdown in the relationship.
3. The contributor dies in the year of the withdrawal.
4. EITHER spouse ceases to be a resident of Canada for tax purposes.
5. You convert your spousal RRSP into a spousal RRIF which is subject to minimum withdrawals. In this case, only the amount of the withdrawal within the Three Year Rule’s range that is OVER the minimum annual withdrawal required for a RRIF account is subject to attribution back to the contributor.
Retirement income equalization is one of the most overlooked areas of personal finance – don’t take it lightly. It should be an integral part of your financial planning from the get go – no matter how far off the goal line is. I’ve had some clients take me aside and express that they have doubts about the long term nature of their marriage and wonder about holding off on the strategy – don’t worry, just do it. Division of property upon relationship breakdown almost always includes your future retirement income anyways, and if you hold off and your spouse finds out why – you may just solidify the dissolution of your relationship! That’s a type of income splitting you want to avoid!
It should also be noted that the investments inside a spousal RRSP account need to fit the risk tolerance and time horizon, etc. of the annuitant – not the contributor. So if you think that just because you make the contribution, you have the final say on what the investments are – “technically” you don’t – although this doesn’t tend to matter to people much. But remember, “technically” the funds belong to the annuitant. Make sure you both understand this ahead of time.