Marriage, in many ways, represents a union of two people as a single unit. But under the Canadian tax system, those two people are still treated as individuals. Each individual is taxed progressively based on his or her own income. The higher income earner pays a higher tax rate than the lower income earner. This progressive tax system creates an opportunity to minimize overall tax on the married unit by shifting income from the higher income spouse to the lower income spouse.
That sounds easy right?
Why doesn’t the higher-earning partner just give money to their spouse to contribute to their investments? Job done.
Not so fast.
There are attribution rules in place that tie the income from those investments back to you. You’ll be taxed on the gains from those investments. The attribution rules prevent taxpayers from reducing taxes by simply shifting investment income to family members.
There are still ways to legally shift income between spouses, you just have to have your accounting in order. For example, you could be strategic in balancing who pays major household expenses vs who makes investments, you can use a Spousal Loan to transfer money, or you could contribute to a Spousal RRSP. Today, we’re focusing on Spousal RRSP.
Aside: the discussions in this article applies to both married couples and common law couples.
Investment brokerages like Questrade and Qtrade both have Spousal RRSP accounts available. Check out FT’s latest Questrade Review, a long time favourite of ours. Also check out Kornel’s latest Qtrade review, recently hailed as the best brokerage in Canada. If you’re having a tough time deciding between these two brokerages, check out FT’s detailed Questrade vs. Qtrade comparison article.
Why Balance Retirement Income?
Imagine a married couple in retirement: Terry and Monica Monica. They are drawing down their retirement savings nest egg to cover their $40,000 annual living expense. Imagine two scenarios:
A) Monica withdraws $50,000 from her RRSP and Terry doesn’t withdraw anything; or
B) Both Terry and Monica each withdraw $25,000 from their own respective RRSP account.
As a couple, they withdraw the same amount in each scenario but how much of the money do they keep after taxes?
In scenario A, Monica must report $50,000 income on her tax return, her marginal tax rate would be 29.65%, and her average tax rate would be 21.55%. She would have to pay $10,775 in taxes. Terry doesn’t pay any taxes as he does not have any income to report. Together, they keep $39,225.
In scenario B, Monica reports only $25,000 income on her tax return. That puts her in a lower tax bracket compared to scenario A). Her marginal tax rate would be 20.05%, her average tax rate would be 15.24%, and she would therefore have to pay $3,811 in taxes. Terry has the same income and therefore the same $3,811 tax liability. The couple’s combined tax burden is therefore $7,622. Together, they keep $42,378.
That’s over $3,000 more compared to scenario – or about one extra Carribean cruise for the couple just for optimizing their RRSP withdrawals.
These calculations are based on simplifying assumptions that the couple’s only income comes from RRSP withdrawals. Tax rates are calculated assuming the 2020 tax year and that the couple lives in Ontario.
Ideally, Monica and Terry should withdraw about the same amount from each of their RRSPs every year to minimize their combined tax liability. To do this consistently every year for the remainder of their retired life, each of them should ideally have roughly the same sized nest egg to start with.
But if one spouse earns a higher income, it may be tough to grow two equally sized nest eggs. That’s where spousal RRSPs come in. It allows the higher income spouse to contribute to the lower income spouse’s RRSP and balance the growth of both nest eggs.
Spousal RRSP Contribution Rules are Very Simple
Let’s say early on in their marriage, Monica earns a higher income than Terry. Monica therefore, has a higher RRSP contribution and deduction limit. Terry can open a Spousal RRSP with himself as the account holder (AKA: annuitant) and set Monica as a contributor. Then each year, in addition to her own RRSP, Monica can contribute to Terry’s RRSP as well. Monica can deduct contributions to both her own RRSP and Terry’s RRSP from her income. However, the maximum limit Monica can contribute and deduct is calculated based on her own income alone.
Terry does not see any immediate tax benefits from Monica’s contributions. He just gets a boost to his nest egg.
And if later on the roles reverse, say Monica changes to part time work or takes time off to go to school, and Terry becomes the higher income spouse, then Monica can set up a Spousal RRSP with herself as the annuitant and set Terry as a contributor. Terry can then use a portion of his RRSP contribution limit to contribute to Monica’s Spousal RRSP.
The couple works as a team to balance contributions to each of their own RRSPs, aiming to grow their respective nest eggs to the same size by retirement. If they can achieve that, they will be in a great position to minimize taxes when drawing down their nest eggs in retirement.
Spousal RRSP Contribution Limits
The rules around spousal RRSP contribution limits are worth highlighting. A person’s RRSP contribution room can be up to a maximum of 18% of previous tax year’s income (up to a maximum for that particular year – for example, for 2020 it is $27,230).
That contribution room can be decreased by pension contributions during the year. Contribution to a Spousal RRSP uses up the contribution room of the contributor. So when Monica contributes to Terry’s Spousal RRSP, she uses up her own contribution room. And vice versa, when Terry contributes to Monica’s Spousal RRSP, he uses up his own contribution room.
The higher income earner slows down growth of his/her own nest egg to help the lower income spouse catch up on their nest egg.
Attribution Rules: Be Careful when Withdrawing a Spousal RRSP
The whole point of contributing to Spousal RRSPs is to plan for and optimize withdrawals in retirement. But, emergencies can happen, and an early withdrawal could be needed. Just be careful of the pesky attribution rules.
Withdrawals must be reported as income on the contributor’s tax return if the contributor made recent contributions. The amount to report on the contributor’s tax return is the lesser of the withdrawal amount and the total contributions made in the last three calendar years (including year of the withdrawal). Any remaining withdrawal amount must be reported as income on the annuitant’s tax return.
Let’s say in 2021, Terry needs to withdraw $4,000 from his Spousal RRSP (in which he is the annuitant). Monica made contributions to Terry’s Spousal RRSP in 2021, 2020, and 2019 totalling $5,000. That $4,000 withdrawal from Terry’s account must be reported as income on Monica’s tax return.
Then, later in the year, Terry withdraws an additional $3,000 from his Spousal RRSP. Out of that withdrawal, $1,000 must be reported as income on Monica’s tax return. The remaining $2,000 must then be reported as income on Terry’s tax return.
The early withdrawal attribution rules complicates record keeping. Best to avoid early withdrawals from a Spousal RRSP. Use other investment/savings instruments to cover emergencies if you can.
Pension Splitting and Spousal RRSPs
Recall that the optimal tax strategy in retirement is to have each spouse take home roughly the same retirement income each year. We talked about using Spousal RRSPs to grow each spouse’s nest egg to roughly the same size in order to balance withdrawals in retirement. That’s one way to give each spouse equal retirement income. Keep in mind that Spousal RRSP is just one tool at your disposal. Pension splitting is another tool.
Pension splitting allows a retiree (age 65 or more) to designate up to 50% of his/her retirement income to their spouse so that the couple as a unit minimizes their collective tax. Some retirement income isn’t allowed to be split but RRSP withdrawals, RRIFs, and income from annuities are allowed to be split.
Some may argue that pension splitting makes Spousal RRSPs obsolete but I think it’s just another tool in the tool box. Tools can be used together to help you optimize your retirement.
Speaking of Tools
After learning about Spousal RRSPs, be sure to check out Kyle’s in-depth article on Withdrawing from your RRSP, TFSA, and Non-Registered Accounts for Retired Canadians. There is some great advice in that article to help you optimize your retirement income and minimize your tax burden.
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