Spousal support: Financing togetherness

(January 2006) A spousal or common-law partner RRSP (hereafter referred to simply as a spousal RRSP) is one of the few explicitly legislated ways to income split between spouses or common-law partners.

The primary benefit of a spousal RRSP is that funds withdrawn can be taxed in the hands of the annuitant spouse instead of the contributor spouse, subject to specific spousal attribution rules. If the annuitant spouse is in a lower tax bracket than the contributor spouse in the year of withdrawal, there may be an absolute and permanent tax savings.

Technically, a spousal RRSP is any RRSP to which one spouse or partner is the contributor and the other spouse or partner is the annuitant. As of 2001, a common-law partner is defined as someone who cohabits in a conjugal relationship with someone of the same or opposite sex for a continuous period of at least one year, or is the natural or adoptive parent of a child of one of the partners.

Clients often get confused as to the amount they can contribute to a spousal RRSP. In fact, it’s really quite simple. Remind your clients they can contribute any amount they wish to either their own RRSPs or spousal RRSPs, as long as the total contributed to all of them in a particular year does not exceed their RRSP contribution limit for that year.

Let’s take Stuart, who earned $110,000 in 2005. His wife, Monique, earned $40,000. Stuart’s RRSP limit for 2006 would be $18,000, which is the lesser of 18% of his 2005 earned income ($19,800) and the 2006 contribution limit ($18,000). Stuart may decide to contribute the entire $18,000 to his own RRSP, a spousal RRSP for Monique or some combination of the two. Stuart’s RRSP contribution limit is not affected in any way by Monique’s own RRSP contributions.

So, what should Stuart do? How does he decide? Unfortunately, inexperienced advisors may look to the easy answer and immediately conclude that since Monique is in the lower tax bracket, Stuart should make all of his RRSP contributions to a spousal RRSP for her. It’s not that simple, however, since the real income-splitting advantage of spousal RRSPs will arise not today, based on the couple’s differing tax brackets, but rather upon retirement and the differences between their relative tax brackets at that time.

Ideally, Stuart and Monique would sit down with a financial advisor and prepare a plan that would attempt to predict both the fair market value of each spouse’s non-registered and registered assets upon retirement, as well as what sources of retirement income the couple will have. Only by doing a full financial plan, and attempting to estimate the tax brackets Stuart and Monique will be in when they have to begin withdrawing money from their registered plans at age 70, can an advisor come up with an optimal spousal/non-spousal RRSP contribution strategy.

Other advisors have also naively suggested another quick fix: Try to ensure that upon retirement each spouse has about the same amount of money in his or her RRSP. While this may be better than having Stuart make his entire RRSP contribution each year to a spousal plan, the main flaw with this simplistic approach is it fails to take into account other sources of income each spouse may have upon retirement.

For example, let’s say Stuart plans to keep working beyond age 69, ultimately providing him with a meaningful source of income, in turn bumping him into a higher tax bracket.

Alternatively, what if Monique stands to inherit a significant sum, which when invested may yield her additional income upon retirement? These factors need to be taken into account and that can only be done with a properly thought-out financial plan.

The Dreaded Spousal Attribution Rule

The Income Tax Act contains a special attribution rule to prevent short-term income splitting with RRSPs. Let’s explore the potential for abuse which could occur in the absence of any anti-avoidance rule.

Let’s revisit Stuart and Monique but this time assume Monique does not work outside the home and has no income whatsoever. In the absence of any anti-avoidance rule, Stuart would simply contribute about $8,000 a year to a spousal RRSP, and the next day Monique would withdraw the same amount. Since Monique has no other source of income, she would not pay any tax on the withdrawal, since the $8,000 withdrawal is below the basic personal amount for 2006 and can be withdrawn tax-free. In other words, Stuart would get a tax deduction for the $8,000 and Monique would pay no tax on the withdrawal — an ideal short-term income-splitting strategy! (Naturally, any advantage would be mitigated somewhat by the loss of tax-deferred compounding inside the RRSP.)

That seems too good to be true, because it is. The Income Tax Act won’t allow this type of short-term income splitting and in response enacted the often-confusing anti-avoidance spousal attribution rule. Simply put, if the annuitant spouse or partner withdraws any funds from a spousal RRSP (or withdraws more than the minimum amount from any spousal RRIF) within three calendar years of any contribution being made to any spousal RRSP, the withdrawal will be attributed back to the contributing spouse or partner and taxed in his or her hands.

So, in this example, Stuart would be forced to include Monique’s $8,000 withdrawal in his own income, which would negate the RRSP deduction he took and make Stuart’s seemingly shrewd attempt at short-term income splitting futile.

Advisors should note the rule will not apply in the year of death — although many would consider this pushing the limits of aggressive tax planning. The rule also does not apply if one of the spouses or partners is a non-resident of Canada at the time of the RRSP withdrawal, nor does it apply if the spouses or partners are living apart at the time of withdrawal due to a breakdown of their marriage or common-law partnership.

Combining Spousal and Non-Spousal RRSPs

A question often asked by advisors is whether a client’s spousal and non-spousal RRSP accounts can be combined, perhaps to save on annual RRSP administration fees or to facilitate asset allocation within a client’s RRSP accounts. These requests occur when one spouse or partner has died or the couple has separated.

The CRA has always permitted the removal of the spousal status on an RRSP account upon the death of the contributor spouse, because there is no way the attribution rule could apply after the contributor’s death. When it comes to the removal of the spousal status upon separation or divorce, the CRA has been less than accommodating historically, saying “even divorced couples may reconcile and therefore the attribution rules may conceivably apply again.” The non-removal of the spousal flag has often been a bone of contention with distressed clients who have to suffer the indignity of seeing an ex-spouse or partner’s name on their RRSP accounts each time they open up their statements.

Finally, after years of lobbying, the CR A amended its administrative policy in this area and announced the change in the 2003 RRSP Consultation in Ottawa. The CRA stated the annuitant can ask the issuer of an RRSP (or RRIF for that matter) to remove the information about the contributor from the plan (or fund), provided certain conditions are met.

The first condition is that the RRSP issuer must have proof the annuitant and contributor spouses are living apart because their marriage or common-law partnership has broken down. Such proof may take the form of a simple written statement, signed and dated by the annuitant, or may simply be a copy of the separation agreement or divorce decree. While this proof need not be submitted to the CRA, the RRSP provider will keep a copy on file for its own records.

Second, there must be no spousal contributions to any of the annuitant’s RRSPs for the year of the request and the two previous years. This would also be evidenced by a written statement by the annuitant that his or her former spouse or partner did not contribute to any of the annuitant’s RRSPs in the calendar year of the request, nor in the two immediately preceding calendar years.

The third and final condition is there can be no withdrawals from the spousal RRSP during the year of the request. In the case of a spousal RRIF, no more than the minimum amount can be withdrawn.

Once these three conditions are met, the RRSP issuer can remove the contributor spousal information from the spousal RRSP. As an alternative, the property can be transferred to a new or existing individual RRSP in the annuitant’s name.

Although the second and third conditions imposed by the CRA may seem superfluous (since the spousal RRSP attribution rule would simply not apply if the spouses are separated), the relaxing of the rules should provide some solace to separated clients who may be continuously irked by seeing their ex-partner’s name on their RRSP accounts.

Jamie Golombek, CA, CPA, CFP, CLU, TEP, is the vice-president, Taxation & Estate Planning, at AIM Trimark Investments in Toronto.

(01/04/06)