Pension Income Splitting

In the fall of 2006, the Department of Finance announced that Canadian residents receiving most types of private pension income (including a pension received from former employer and, where the recipient was over the age of 65, payments from a registered retirement savings plan or a registered retirement income fund) would be entitled, beginning with the 2007 tax year, to split up to half that income with a spouse for tax purposes. (Payments from the Canada Pension Plan or Old Age Security payments do not qualify for pension income splitting). Since then, a number of provinces have indicated that they will adopt the federal proposals for provincial tax purposes.

While the news that pension income splitting (and the potential for tax savings to be achieved from such income splitting) was to be made available was certainly welcome, the federal government's announcement was short on details. In particular, the announcement raised but did not answer questions relating to the effect that splitting pension income would have on a taxpayer's eligibility for other federal tax credits (like the GST credit) or on a taxpayer's eligibility for Old Age Security payments. Similarly, no details were provided on the mechanics of how such split income was to be reported on the annual tax return.

The Canada Revenue Agency has now released a Q&A document which addresses many of these concerns, as follows.

How to elect to split pension income

A new form--T1032 Joint Election to Split Pension Income - will be released by the CRA by January 2008. On that form, the taxpayer receiving the private pension income and the spouse with whom part of that income is to be split must make a joint election to be filed with their respective tax returns for the particular tax year. Since the splitting of pension income affects both the income and the tax liability of both spouses, the election must be made and the form filed by both spouses--an election filed by only one spouse or the other won't do.

In addition to filing the T1032, the spouse who actually received the pension income must deduct from income the pension income amount allocated to his or her spouse, and a new line will be added to the federal income tax return for this purpose. And, conversely, the spouse to whom the pension income is being allocated will be required to add that amount to his or her income on the return. Once again, a new line will be added to the T1 form for that purpose.

There is no requirement or need for the taxpayer to contact or inform the payor of the pension income which is to be split. All payments of pension income will be continued and information slips will be issued by the payor in the same manner as would be the case if no income splitting was taking place. It's important to note, however, that where tax is withheld from the income to be split, that tax will have be allocated on the return for the year in the same proportion as the pension income is allocated.

Effect of pension income splitting on eligibility for other federal credits and benefits

Eligibility for a number of federal tax credits and benefits is based, in whole or in part, on a taxpayer's net income or on family net income. Under the rules outlined in the release, splitting of pension income will decrease the net income of the pensioner while increasing the net income of the spouse with whom the income is split. Consequently, where eligibility for a particular federal tax credit (the GST/HST, for example) is based on family net income, splitting of pension income will have no impact on either eligibility or amount received, since overall family net income is unchanged. Where, however, a tax credit or benefit is calculated based on one individual's net income, the splitting of pension income can create real benefits.

For couples over the age of 65, the ability to minimize or eliminate any clawback of Old Age Security Benefits through pension income splitting can be significant. Most Canadians are eligible to receive such benefits, which can reach about $500 per month, after they turn 65 years of age. However, taxpayers who have net income of more than about $62,000 (with the amount indexed annually) have their benefits reduced or "clawed back". The clawback rate is 15% of net income over the threshold amount of $62,000. Taxpayers having income of more than about $101,000 receive no benefits at all.

As an example of the benefits which can be realized, take the situation of the couple where one spouse has annual retirement income of $85,000, from various sources, including eligible pension income, and the other has no private retirement income at all. At those income levels, the lower income spouse would have full OAS entitlement, but the spouse with the higher income would lose just over half of OAS benefits. If eligible pension income is split such that both spouses have income below $62,000, both would enjoy full OAS entitlement, amounting to about $12,000 for the year. Absent pension income splitting, the couples' total OAS entitlement for year would have been just over $8,500.

Finally, taxpayers receiving private pension income can claim a non-refundable federal tax credit of up to $2000 on their returns for the year. The actual credit claimable is equal to the amount of qualifying pension income earned or $2,000, whichever is less. The CRA has confirmed that where pension income is split, the amount of such income reported for tax purposes by each spouse will be used to determine eligibility for and the amount of any pension income credit. For example, where a taxpayer who receives $10,000 in eligible pension income for the year allocates 50% of that amount, or $5,000, to a spouse, both spouses will be able to claim the full $2,000 pension tax credit on their return for the year the income is reported.  

Pension income splitting, tax instalments and withholdings at source

It's usually the case that tax is withheld at source from private pension income and, in addition, retired taxpayers are often subject to tax instalment payment requirements four times a year. The effect of pension income splitting is, however, different for each tax payment method.

When it comes to tax withholding at source, the CRA's position is unequivocal, as it states in the recent release that "the CRA cannot approve a reduction of tax withheld at source based on an election to split pension income".

Taxpayers who pay their taxes in whole or in part by instalment payments have more flexibility, although that flexibility is not without risk. Taxpayers who make instalment payments receive instalment reminders from the CRA, and those reminders indicate the amount to be paid by each quarterly due date. However, the taxpayer is free to determine the instalment payment to be made based on his or her estimation of the tax which will ultimately be owed for the year. Therefore, where pension income is to be split between spouses, the pensioner is entitled to estimate the tax savings to be realized and to reduce tax instalments by that amount. However, as is the case with all instalment payments of tax,if the amount paid by instalment turns out to be less than the actual tax liability for the year, instalment interest will be charged by the CRA.

The ability to split pension income between spouses has the potential to achieve real and permanent tax savings and to enhance eligibility for certain federal tax credits and benefits. As long as the administrative requirements outlined above are followed, pension income splitting is a win-win opportunity for eligible taxpayers.