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Do You Still Need a Spousal RRSP for Income Splitting?

Yes. Yes you do!

A financial adviser said to me a couple of years ago that there was no need for us to setup a spousal RRSP since we now had pension income splitting in Canada. It turns out that advice is not very good. Spousal RRSPs are absolutely still necessary in order to have income splitting options available when it comes time to withdraw.

What is a spousal RRSP?

A spousal RRSP is just like a regular RRSP except contributions are made by the spouse, not the account holder. The spouse of the account holder claims the deduction on their income tax.

In our case, my pre-tax income is about 2.5 times more than Mrs. CFG’s. As such, it’s more beneficial for me to make RRSP contributions since I’m in a higher tax bracket. I’ve been doing that for several years, but contributing to my own RRSP.

Last month, Mrs. CFG opened a spousal RRSP. Now I make my RRSP contributions as before; however, instead of contributing them to my own RRSP, I contribute them to Mrs. CFG’s. I still get the same tax deduction as before and it still reduces my available RRSP contribution room. The difference is the money is now in an RRSP owned by Mrs. CFG. When it comes time to withdraw the money, it will be taxed as income to Mrs. CFG instead of to me.

Withdrawing from an RRSP

For a long time, I had assumed that money in an RRSP was pretty much locked in until retirement. I imagined there was some kind of big penalty for touching that money sooner. That’s not the case at all though. You can actually withdraw money from your RRSP anytime without penalty.

When you withdraw from an RRSP, whether you do so at 35 or 65, the amount withdrawn is treated as income and you are taxed accordingly. The assumption of course is that you’ll be earning less income in retirement and thus in a lower tax bracket when you withdraw from your RRSP.

If you do withdraw money early from your RRSP, keep in mind that you will never be able to re-contribute that amount. The contribution room is gone forever. Also be aware that your financial institution is required to hold back a withholding tax on any withdrawals you make. At the end of the year when you file your taxes, the correct amount of tax based on your income for the year is calculated. If it’s more than the withholding tax amount, you’ll owe money to Revenue Canada. If it’s less than the withholding tax amount, you’ll get a refund.

Pension income splitting

We now have pension income splitting in Canada. This means that you can transfer up to 50% of your eligible pension income to your spouse. This is great as it can greatly reduce your tax bill in retirement. Let’s say that you will receive $50,000 in pension income in a given year and your spouse will not receive any. Without income splitting, you’d be on the hook for approximately $8,000 in taxes. On the other hand, if you split 50% of this income with your spouse, you’d each only be reporting $25,000 of pension income and would collectively owe just $5,000 in taxes.

Here’s the catch though: you can only split eligible pension income. As per CRA’s definition, RRSP withdrawals only count as eligible pension income if you are 65 years or older.

So if you don’t touch your RRSP money until you are 65, then it may be true that you don’t really need to worry about spousal RRSPs and can simply rely on income splitting. There are two common scenarios, however, where you would certainly wish you had setup a spousal RRSP:

Retiring before 65

Anyone who is planning to retire before 65 (we plan to retire at 56), should keep in mind that they will not be able to split income from their RRSP with their spouse. Ideally, each spouse would have enough money in their RRSP to provide the couple with flexibility on which RRSP to withdraw from in order to minimize their taxes. For example, consider a couple in their late 50s. One spouse has fully retired and has minimal income. The other spouse is still working part time and earning a modest income. Unfortunately, the spouse that is still earning income holds all of the couple’s RRSPs. Any withdrawals would be taxed at the higher rate. If instead they both had RRSPs, the lower income spouse could withdraw money with a minimal tax bill.

Financial hardship

While we might plan to never touch our RRSPs until we retire, we never really know what challenges life might throw at us. Consider a situation where one of us loses our job, faces a major health issue, or we land in some kind of serious financial hardship. In those situations, we may need to dip into RRSPs early. If both spouses have RRSPs, the withdrawal can happen from the lower income spouse at the time. If the majority of RRSP money is sitting with only one spouse you’ll have no choice but to include the withdrawal and pay tax based on the income of that spouse, even if they are in a much higher tax bracket at the time.

Conclusion

I would strongly recommend that every couple tries to keep a roughly even amount in each person’s RRSP. This provides the most flexibility when it comes time to withdraw, especially if that withdrawal happens before age 65. Setting up a spousal RRSP is a great way to make this happen in the case where one spouse earns substantially more income than the other.

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