Income Splitting, Trick or Treat?

By : Richard Rizi, CFP

The moon is full, the night is young, and a cold wind blows the leaves down the street. As the darkness deepens, the streets fill with ghosts and witches. Suddenly there is an eerie knock on the door - is the neighborhood suddenly haunted, or is it that one night of the year that many young and old look forward to?

Each of us have our own fond memories of Halloween. While some of us remember hiding under blankets watching horror movies, others may remember dressing up and going trick or treating in search of the ultimate prize, a gloriously full bag of candy.

Although Halloween traditions are different across the globe, lately in Canada, October 31st has served as the launching date for many new federal government announcements that have greatly affected the Canadian investment and retirement landscape. It was on Halloween, 2007 when our federal government increased the basic personal tax exemption to $9,600, it was also when the much maligned GST was cut from 6% to 5%. Of even greater importance to Canadian pensioners and individual investors, was the announcement made on Halloween 2006, that income trusts would be subject to a distribution tax.

Almost lost in the post Halloween stock market mayhem was the promise to finally allow for pension income splitting between spouses (beginning in 2007). Trumpeted as a treat for retirees, the much anticipated and hard fought for tax fairness policy allows Canadians over the age of 65 the ability to split both their pension income as well as any RRIF or annuity income with their spouse. For those under the age of 65, the same policy basically only allows for the splitting of Defined Benefit or Defined Contribution pension income, and specifically excludes the splitting of income derived from an RRSP or RRIF.

Income splitting has many benefits, with the major attraction being the opportunity to transfer pension income from a spouse in a high tax bracket to a spouse in a lower one. Doing this allows spouses who are close to having their OAS and other credit amounts clawed back the ability to better manage their incomes and ensure that they receive the maximum benefit from these programs.

But retirees beware, while heralded as a treat for taxpayers, pension income splitting is not without its perils. Many seniors entering long-term care facilities have learned this the hard way. Although an effective way to lower a household's overall tax bill there are fine points that should be looked at carefully to ensure the optimal split is chosen.

Many couples aren’t aware that incomes are calculated separately when entering a long-term care facility. Normally, a low earning spouse would qualify for a rent subsidy which would reduce the monthly cost of care. However, this spouse may find they no longer quality for this subsidy after income is transferred to them from their higher income earning spouse. Thus the resulting increase in their long-term care cost may exceed the taxes saved through income splitting. On the same theme, medical credits could also be negatively affected and increase the income of the lower taxed spouse might reduce the amount saved from this credit.

As many retirees are discovering, you don't have to split pension income in half. In fact finding the optimal split is much like finding the right balance between stocks, bonds and cash in your portfolio in that the right split is specific to the individual. Before deciding the optimal amount of income to split, or what tax and investment strategies to employ, seek out a professional who takes a holistic approach to planning the best direction for your future.

So this year, rather than hide from those scary thoughts of retirement and taxes, plan ahead and enjoy the years to come. And on Halloween night, open the door when you hear that eerie knock and join the celebration!