The case for spousal RRSPs

It’s RRSP season. Inevitably, clients who have waited until this final month to make 2010 contributions will ask lots of questions. Beyond “Should I make a contribution at all?” and “What should I invest in?” there is, “Should I contribute to a spousal RRSP?”

With the advent of pension income splitting in 2007, many think spousal RRSPs aren’t necessary and don’t provide additional benefits. That’s simply not the case. For many families, spousal RRSPs can continue to provide great benefits.

Spousal RRSPs can allow more flexibility than pension income splitting, and the two options can actually work well together. Pension income splitting is limited to one-half the recipient’s eligible pension income. By using a spousal RRSP, a person can effectively direct any amount of RRSP or RRIF income to a spouse. This can be beneficial when the higher-income spouse continues to work or has other significant income in his or her retirement years.

Those with earned income (including director fees, business income, royalties and rental profits) beyond age 71 and who have younger spouses or partners can continue to make spousal RRSP contributions. This allows for a prolonged deferral of tax in relation to amounts contributed.

Another important distinction between spousal RRSPs and pension income splitting is that spousal RRSPs can be used as an income-splitting tool well before retirement. Under the pension income-splitting rules, only eligible pension income can be split. In the case of RRSP or RRIF income, this means the transferor must be at least 65. But with a spousal RRSP, the annuitant spouse can withdraw the funds anytime, with the withdrawal being taxed in his or her hands. The thing to watch for is the special attribution rule requiring a taxpayer to include in income any RRSP benefit received by his or her spouse or partner—to the extent the taxpayer has made a deductible contribution to a spousal plan in the year or the two preceding years.

This means a high-income spouse or partner can get the tax benefit of making contributions to a spousal plan at a high tax rate. After a three-year non-contribution period, the low- or no-income spouse can withdraw funds and pay little or no tax. This may be particularly advantageous in providing additional family funding when a lower-income spouse takes time off work, perhaps to raise children or start a business that isn’t expected to earn profits for a number of years.

A warning: The funds withdrawn from the RRSP cannot be re-contributed to the plan at a later date without drawing down on future contribution room. So if your client is counting on RRSPs to fund retirement, he or she should ensure these withdrawals do not have a detrimental effect on the retirement plan.

Another important point is that pension income splitting is not a physical split of money; it’s only an allocation of pension income for purposes of taxation. That means the lower-income spouse is not accumulating capital. By using spousal RRSPs, the RRSP income becomes capital to the recipient and can be invested to earn additional income (not necessarily pension income). From those accumulated funds, further income splitting can be achieved.

This doesn’t mean spousal RRSPs should be used instead of pension income splitting. Depending on your client’s personal situation, the strategies can be combined in a manner to produce the most effective financial and tax results.