What Is A Spousal RRSP? And Why Should You Use It?
Fee-for-service financial planner and founder of PlanEasy.ca
Income splitting is often talked about in reference to high-income earners, but what about the average Canadian family? For high-income earners there are income splitting strategies like spousal loans or “income sprinkling”. Spousal loans are for families with lots of non-registered savings and a large difference in marginal tax rates between spouses. “Income sprinkling” can be used by families who own a corporation (although with the new TOSI rules has changed dramatically).
But what about your average Canadian household? Are there are income splitting options for them?
One very accessible type of income splitting is a spousal RRSP. Unlike other income splitting strategies this one is very easy to set up, it doesn’t require a lawyer, and it’s easy to understand.
The big benefit of a spousal RRSP is that the average family can use it to “equalize” their registered assets before retirement. This allows for a more equal distribution of income in retirement and a lower overall tax bill for a household.
In addition to lower income tax it also opens up more opportunities to maximize government benefits in retirement.
But you might be wondering, isn’t it possible to split income after age 65 anyway?
While its true that after age 65 income splitting is much easier to do, it’s still a best practice to try to equalize registered assets before age 65. This allows for the maximum flexibility when creating a retirement drawdown strategy, especially when retiring early.
Equalizing registered assets can be extremely beneficial, especially before the age of 65 when there are fewer income splitting opportunities, for this reason we sometimes want to look at using a spousal RRSP to help split income in the future.
What Is A Spousal RRSP?
You can think of a spousal RRSP like a tunnel from one spouse to the other. One spouse can contribute to the spousal RRSP and deduct the contribution on their tax return, and then the money flows through a “tunnel” to the partner which can then be withdrawn in their name in retirement. Money goes in one side at a high tax rate, and comes out the other side at a much lower tax rate.
This is one of the few ways to legally split income with a spouse. But it has limitations.
The first limitation is that you need to use your own RRSP contribution room to contribute to a spousal RRSP. Contributions to a spousal RRSP reduce your contribution room, not your spouse’s.
The second limitation is that you need to wait two years after the year you made a contribution to make a withdrawal, otherwise the withdrawal will be taxed in your hands and not your partner’s. This income attribution can be a bit tricky for those trying to take advantage of a spousal RRSP directly before retirement, so plan carefully.
The third limitation is that it’s only worthwhile if you expect a tax differential between your current income tax rate and your spouse/partners tax rate upon withdrawal. For example, two people who are both in the 20% tax bracket now and in retirement may not benefit from a spousal RRSP.
Lastly, you need to take into account pension income before deciding to use a spousal RRSP. Pension income is taxed as ordinary income much like RRSP/RRIF withdrawals. So if either partner has a defined benefit pension then this will need to be considered before using a spousal RRSP.
How Much Can You Contribute To A Spousal RRSP?
Because contributions to a spousal RRSP will reduce your contribution room and not your spouse’s, the maximum that you can contribute to a spousal RRSP is your RRSP deduction limit for the year.
As you earn employment income your RRSP deduction limit will increase each year so it will be possible to contribute more to a spousal RRSP each year as you create new contribution room.
Your RRSP contribution limit can be found on your Notice of Assessment or by logging into the myCRA portal.
Advantages of Spousal RRSP
One of the main advantages of a spousal RRSP is that we can more equally split income before age 65. This can be a huge advantage for early retirees.
Equalizing income tax in retirement can save thousands of dollars per year in lower income tax payments. This means that an early retiree who has carefully planned ahead can potentially have thousands LESS in their investment portfolio and still support the same after-tax spending goal.
One interesting advantage of the spousal RRSP is that you can make contributions if your spouse is younger, even if you can no longer make RRSP contributions yourself (for example after age 71). This can be an advantage in certain situations where we want to maximize government benefits in retirement. We can use RRSP contributions to offset other types of income, reduce net income, and increase government benefits.
“After December of the year you turn 71 years old, you can contribute, up to your RRSP deduction limit, to a spousal RRSP or common-law partner RRSP, if your spouse or common-law partner is 71 or younger on December 31 of the year you make the contribution.” Source
The last advantage of a spousal RRSP is that it’s possible to take advantage of “tax rate arbitrage”. By using a spousal RRSP its possible to contribute at a high tax rate and have your spouse withdraw at a much lower tax rate in retirement. This is especially helpful when you already expect to have a higher income tax rate than your spouse in early retirement.
Spousal RRSPs Aren’t For Everyone
Spousal RRSPs aren’t for everyone. Not everyone needs to use a spousal RRSP to have equal income in retirement. For couples who are contributing to their RRSP equally, and who have similar registered investments prior to retirement, the benefit of a spousal RRSP is low.
Also, households who have pension income will have additional income splitting opportunities before age 65. In early retirement any income from a defined benefit pension can be split and this can reduce the need for a spousal RRSP.
The three year attribution rule on spousal RRSPs can also be limiting for some couples. If for cash flow reasons you or your spouse need to withdrawal before reaching the three year mark then a spousal RRSP may not be worth the trouble. This is an important consideration before using a spousal RRSP.
Consider Spousal RRSPs In Your Plan
Spousals RRSPs are an amazing income splitting tool for average Canadian families. It requires very little work to set up and it can lead to thousands (if not hundreds of thousands) in potential tax savings in retirement.
It can also make it easier to maximize government benefits in retirement, avoid OAS clawbacks and/or avoid GIS clawbacks.
But a spousal RRSP isn’t for everyone. It’s important to consider how a spousal RRSP fits into your overall financial plan. It’s important to understand income tax and government benefit clawback rates both now and in retirement. Only then will it be clear if a spousal RRSP is a good income splitting option for you.
Financial planner, personal finance geek and founder of PlanEasy.