The Canadian Money Roadmap
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The Canadian Money Roadmap
Maximizing Retirement Savings and Tax Benefits with Spousal RRSP Strategies
Unlock the full potential of your retirement savings with our latest episode, where we unravel the power of spousal RRSPs. As the RRSP deadline looms, we delve into strategies that not only prepare you for a stable retirement but also smartly align your savings with your current income bracket to maximize tax benefits. With an eye on the future, we discuss how adjusting your contributions can significantly reduce your taxable income now and how a spousal RRSP can be a game-changer for couples, particularly where one spouse earns a higher income.
Our conversation extends beyond just RRSPs, as we explore the clever use of spousal RSPs for income splitting, which can be especially advantageous in single-income, households. We dissect the three-year rule that prevents immediate withdrawal by the non-contributing spouse. This episode doesn't just throw numbers and rules at you; it integrates these strategies with other financial vehicles like TFSAs and FHSAs, painting a comprehensive picture of how to stretch every dollar for a financially secure horizon. Join us as we guide you through these pivotal strategies, ensuring you're equipped to make informed decisions that could pay dividends in your golden years.
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Hello and welcome back to the Canadian Money Roadmap Podcast. I'm your host, evan Newphill. We're into February, and so that means people are looking at their RRSP's and looking to maximize the benefit from it. In this episode, I'm going to be talking about a strategy that you might not have considered before, which loops in the spousal RRSP. Welcome back to another episode here, if you are joining me in February. We are coming up on the last few days of contributing to an RRSP for the 2023 tax year. Rrsp's are a little unique in that they are less based on the calendar year and more so connected to the tax year. You get the first 60 days of every year to contribute for the previous year. That way, you have enough time to figure out how much income you had in the past, so you can optimize your contributions based on years when you know you had a certain level of income. Before I get into the meat of the, I'm going to recommend today, for those of you who are new to RRSP's or need a bit of a refresher, I'm going to start there how RRSP's so that's registered retirement savings plans work in general. The way that it works is that when you contribute to an RRSP, you get a deduction on the way in. A deduction means that it reduces the amount of income you have that can be taxed. So if you have $100,000 of taxable income and you make a $1,000 RRSP contribution now, you only have to pay taxes on $99,000. So the RRSP contribution deducts from your taxable income, meaning you will pay less in taxes on the way in. So once the money is in the RRSP, it can be invested in many things that you would think about stocks, bonds, mutual funds, etfs, cash pretty standard things that people might have in combination inside of an RRSP. Then, when it comes time to take money out, you will have to include every dollar that you take out in your taxable income that year. So, just like your employment income, when you receive income, you pay taxes on it. The RRSP will end up working the same way. When you take the money out, you pay taxes at that point. So you don't pay tax on the way in, but you pay taxes on the way out. All sorts of different ways to think about this and calculate it, because there's so many variables that are applicable for people with RRSP's. So, depending on your tax rate, you could, in theory, pay more in tax. By using an RRSP, you could pay the same in tax or you could pay less in tax compared to some alternatives like using a tax-free savings account or a non-registered account. So it all depends on your sources of income when you withdraw. I don't say that to scare people, because the vast, vast, vast majority of people will benefit from using an RRSP, because the main benefit of an RRSP is based on the tax deferred growth, which is probably much more valuable than people really give it credit for once, you start crunching the numbers and add some realistic scenarios to it but also the ability to benefit from the differential in tax rates between when you contribute and when you withdraw. Let's use a hypothetical example here. So say you're a high-income earner and during your working years you might be in the top bracket. Every bracket is different for every province, so I'm just going to use round numbers here. Let's call it the 50% tax bracket. But then in retirement, for a number of reasons and I'm going to have a whole episode on this as to why this might be the case but it's very likely that you are going to find yourself in a lower tax bracket come retirement. So you might be in the 33% bracket when you retire. So the simple math, which ignores time value and potential investment, growth and whatever, but just dollars in, dollars out and taxes in between. Let's say you made a $10,000 contribution. In my hypothetical scenario, that would reduce your income by $10,000, which means you would get a $5,000 refund if you've already paid taxes on that money, which you would have if you had employment income, like most of you listening. Okay, so $10,000 goes in, you add a $5,000 refund. Then later on, again ignoring potential growth, $10,000 comes out and if you're in the 33% tax bracket, that means you pay about $3,300 in tax. So the difference there is the difference between $5,000 and $3,300, $1,700. Maybe this gets much better once you start to incorporate some investment growth over the course of your life. But just high level. I wanted to talk about the main benefits there. So if you can have that benefit of a differential in your tax rate, that is a great opportunity to use an RSP. How do you know what your tax rate is going to be in retirement? Well, taking a look at a financial plan can help you project that a little bit. But also, your current tax rate is the easier one to know, and so if you're currently in one of the lower tax brackets in your province and you anticipate being a good saver over your career, it is very likely that you would probably be in the similar tax bracket come retirement. So this is why I kind of have this default recommendation of people really considering RSPs once they're in higher than the middle tax bracket, depending on your province. That's often when income is over about $110,000. But there's so many different variables it's hard to give a blanket answer here that is relevant for everybody. So I would encourage you to work with a professional to find a plan that makes sense for you if you're looking to optimize the RSP, so talk to high level here about how an RSP works. Let's get into the specific strategy. That is a little bit different. There's another type of RSP account that you can open if you have a spouse or a common law partner, called a spousal RSP. What this does is it allows you to invest money in your spouse's name with the goal of withdrawing it in their name and their tax rate later. The tax rate is the big thing, so sometimes this shows up when there is a primary income earner in the household or if somebody has a pension that they're going to have a lot of taxable money in the future, file that under good problems. But using a spousal RSP helps the process of income splitting later on in life and the benefit there being paying less overall in taxes. So how does a spousal RSP work at a high level? Let's just work through a hypothetical example. So you, listening, assume you are the high income earner in your household and your spouse might be someone that has lower income or no income because they might be a stay at home parent or something like that. A spousal RSP would be set up in your spouse's name, but any contributions that would go into that plan would be based on your tax rate and also require you to have the RRSP room to contribute. So you can't borrow their RSP room and you get the deduction or anything like that. It's functionally the same as you having the RSP, but the money ends up in their name. But that is the critical part. So how could this strategy work best? Before we get too far, your wheels might already be turning and you say, oh okay, well, if I contribute, I get 50% deduction, my wife doesn't work, she can take the money out and pay no taxes, and then we can just essentially avoid taxes on a bunch of money every single year. Great idea, but it doesn't work like that, okay. So to prevent people from taking a grievous advantage of this income splitting opportunity using spousal RSPs, there's a rule that says that any income withdrawn can be attributable back to the contributing spouse if there's been a contribution made this calendar year or any of the previous two calendar years. So think of this just like a three-year rule, but technically it's kind of like two years in a day if you make the contribution at the end of December. So the big idea here is that the money needs to be parked in this Sposal RSP for about three years before it can be attributable to the other spouse. Okay, so this takes some planning, but for those of you in this situation it might well be worth it. So again, how it would work best here. So say, there's a single income household with a high income earner let's call that you, okay, person that's listening, you're the high income earner in your household. Then you have a spouse who doesn't earn an income and has no intention of earning a meaningful income over the next three years. Right, so that gets you outside of the income attribution pocket. Then the high income spouse has to have RSP room because, again, like I mentioned before, it uses their room or your room, I guess by example here and gives you the deduction. So you have to have the RSP room. So then you can open up a Sposal RSP in the lower income earner's name. You, as the high income earner, are the contributor, and then you can make a contribution there out of cash that you have on hand that you're planning to invest for the long term. Great, when all is said and done, you, the high income spouse, will receive the deduction for it, all based on your tax rate. Once the money's in there, we kind of sit around and wait for the end of this calendar year and then two more years to pass, because at that point now you can withdraw from the Sposal RSP and that income, like I mentioned at the beginning, when you take any money out of an RSP, it gets treated just like income. The three year period here is critical, though, because now that income will be attributable to the lower income spouse or the spouse that had this account in their name, so it all depends on their total income at that time. So if you withdraw 10,000, then 10,000 will be added to their taxable income that year. The cool thing is, with very few high income exceptions, everybody gets about 15 grand tax free. That amount changes every year, but it's in that ballpark every year. So this could be kind of the target amount if you're looking to pay absolutely no taxes. So let's just do the hypothetical here again. So in theory you could contribute in the 50% bracket ish if you're a very high income earner in your province and then you wait three years after the income attribution period of time has passed. Then you're supposed to withdraw about $15,000 ish in the 0% bracket. This takes my previous example of $10,000 goes in and you get a $5,000 refund and then $10,000 comes out but you pay virtually no tax. Again, all depends on your situation, but there could be a $5,000 benefit there waiting for you on that tax rate differential. It might sound almost too good to be true, but there's so many things that have to be in place for this to actually be applicable to your situation. But if you're planning to use this for a long term growth optimizing strategy and not just some sort of three year income splitting thing where you're just going to end up spending all the money anyways, the idea is that you want to keep that money invested. So you could do two things. One, you could just leave the money in there and not worry about the three year rule thing, necessarily until you get closer to retirement. So that works just fine. But if you're wanting to take full advantage of your TFSA as well, if you or your spouse have TFSA room, you could use that withdrawal to make a TFSA contribution. That way you can benefit from the tax-free growth that you have in the TFSA even after benefiting from the tax rate differential benefit from the RSP. The opportunity here is pretty significant, especially if all of those are applicable to your situation. So there's another thing that you could do is there's an opportunity to use this in conjunction with the FHSA, the first home savings account, if that's applicable to you, meaning you haven't owned a house as a primary residence any time in the last four years. The main thing is because you don't have to have RSP room to open an FHSA, but you still get another income deduction from it. So this is getting into really niche territory, but it could be a really cool planning opportunity if you have this situation of having a high-income earning spouse, a low-income earning spouse, time on your hands before you want to buy a house. You've never owned a house before but you plan to in the future, even if you're gonna be a lifelong renter. The FHSA could be a great opportunity to manage your tax bill because you don't need that RSP room and if you get to the end of the life of the FHSA 15 years later you can transfer that back to your RSP as well. So it's kind of like a churning opportunity here. But that gets a little bit more complicated. So it's just sticking with the Sposal RSP contribution and withdrawing three years later. A few things I want to highlight as reminders here. First thing again, the contributing spouse needs the room. So you can double check that on your Notice of Assessment or on your CRAMI account to make sure that you actually have room to contribute to a Sposal RSP. Second thing the income attribution rules, meaning when can that withdrawal be counted for the lower income spouse? It uses kind of a last in, first out philosophy so you cannot be contributing any time during that waiting period. So there needs to be a three-year stop on all contributions before you can make a withdrawal in the receiving spouse's name and tax rate. There is a wrinkle if you are listening to this and you are closer to retirement and you're considering this as part of your retirement income strategy, if you convert your RSP to a RIF which you have to do at age 71, but you can do it anytime before that the minimum amount that you have to take out of a RIF. So again, an RSP is kind of like a bucket. But a RIF is a bucket with a hole in it. The hole in it is the minimum amount that you have to withdraw every year. You can avoid the three-year income attribution period by just taking out the minimum amount, and that minimum amount is not attributed back to the contributor. So there's some opportunities there if you find yourself in a situation where you accidentally made a contribution in the last three years but still want to take advantage of this. Again, probably works better if you're closer to retirement, but everything is situational. Another thing to keep in mind your RSP room is gone after making that withdrawal. So this isn't like the TFSA where you can re-contribute money that you take out of it. No, the RSP is very different that way. So you will lose that RSP contribution room once you make the withdrawal. If you have TFSA room like I said before, tfsa or FHSA and you want to contribute there afterwards. That also works great, but just know that the RSP room is gone and you can't do this again without earning more room along the way. Last thing, like I said, this is the kind of complicated version of doing it over a three-year period of time, but it works great as a long-term strategy. If you are a high-income earning person contributing to your spouse's RSP and you both have similar amounts of RSPs come retirement, you can split things relatively easily, especially before age 65. That's a nice thing to consider there as well. But you just get a little bit of that less immediate benefit and potentially less significant benefit if you're going from the top bracket down to the zero bracket and then into a TFSA or an FHSA. Okay, so that is kind of the complicating factor that you can consider here. So again, this is not going to be something that is applicable for everybody, but I hope you found this episode kind of interesting, looking at some of the unique planning opportunities that exist out there and things that we as financial planners look for from time to time, depending on someone's situation. So let me know what you think, shoot me an email over at podcast at evanuefieldcom. Thanks so much for listening to this episode and we'll see you next week with another one. Thanks for listening to this episode of the Canadian Money Roadmap Podcast. Any rates of return or investments discussed are historical or hypothetical and are intended to be used for educational purposes only. You should always consult with your financial, legal and tax advisors before making changes to your financial plan. Evan Neufeld is a certified financial planner and registered investment fund advisor. Mutual funds and ETFs are provided by Sterling Mutuals Inc.
