Using Income Splitting to Protect the Surviving Spouse
Couples have it easier than singles in retirement. Not only do they have two sets of payments from CPP and OAS, but there are also tax advantages. Thanks to these benefits, retirees often need less total income than they think they will.
However, if one spouse dies early in retirement it could cause the survivor to have significantly less after-tax income. Retired couples may want to take full advantage of income-splitting opportunities while they can. By paying taxes now at a lower rate, it is possible to save the surviving spouse from taxes in the future.
Tax savings of two retirees
The primary method of reducing taxes in retirement is by splitting income. This transfers taxable income from the high-income spouse to the spouse with lower income. By balancing the income of the spouses, the total amount of tax paid is reduced. This is because of our progressive tax system, where the tax rate increases as the income level increases.
If one spouse has the majority of the income, then they will likely pay tax in higher marginal tax brackets. By splitting their income, the couple can make full use of the lower tax brackets and avoid paying at higher rates. It can also help them get more value from income-tested tax credits such as the age amount and reduce the OAS clawback.
These tax advantages can add up to major savings:
Example of two different households
Let’s take a look at the taxes payable in 2022 for two different Manitoban households:
In the first case, we have Joan, who is 65 and widowed. She has $100,000 of taxable income, coming from a combination of CPP, OAS, pension, and RRIF withdrawals.
Based on her income and tax credits, her total tax payable will amount to $26,308. There will also be $2,736 in repayments to OAS for income above the clawback threshold.
The second household is that of Brian and Kim, who are also aged 65. They each have $50,000 in retirement income, for a combined total of $100,000.
In contrast with Joan, the combined tax that they pay is only $17,085, without any OAS clawback. With the same amount of total income, the couple pays almost $12,000 less in tax.
Options for splitting income
The most common forms of income splitting in retirement are:
Planning for the surviving spouse
When creating a retirement plan, it is generally recommended to assume a long lifespan. However, it is also important to consider what would happen if one spouse were to die early. This allows us to see if they would have enough income for their needs.
If one spouse were to die early in retirement, the first income drop would be from a reduction in CPP and OAS, whose survivor benefits are limited. The surviving spouse may also have to pay higher taxes on their remaining income.
The key question is if there would be enough money for the survivor after these reductions are considered.
If there isn't, it may be worth drawing additional income while both spouses are alive. This would come from registered accounts (RRIF), with the intention to build a reserve of tax-paid funds. If there is TFSA contribution room available, then money could continue to grow tax-free.
Taxes now vs taxes later
There is a trade-off to this strategy. Drawing extra money from RRIFs and paying tax on it means you will no longer enjoy continued investment growth on the taxes paid. This would be less efficient if both spouses were to live a long time. Over time, this loss of tax-deferred growth can be substantial.
The goal of this strategy should be to ensure that a surviving spouse would have enough tax-after income to be comfortable. Once that has been achieved, additional withdrawals should be weighed against the immediate tax cost.
Make a plan to split your retirement income
Income splitting in retirement is a tremendous savings opportunity for retirees. The potential tax savings are well worth hiring a financial planner to ensure that you can take full advantage of it.
Our uncertain lifespan makes planning for retirement income difficult. While it's impossible to plan for every scenario, we can still take reasonable steps to protect our loved ones.
