There are three tax planning strategies – Deduct, defer and divide.  Income splitting is a way of dividing income and pension splitting is a great strategy to help couples reduce taxes.  Sometimes rules can be confusing so I thought I would share a few examples of real life people who were able to take advantage of pension income splitting

One pension household

Rick is 66, self employed and still working.  His wife Susan has retired at age 60 with a $1200 per month pension plus $325 per month from Canada Pension Plan.

Although Susan can give up to $7200 to Rick under pension splitting, she should no because Susan is in a 25% marginal tax rate and Rick is in a 36% marginal tax rate.

Since Rick does not have a pension, Susan can give Rick $2000 of her pension so that he qualified for the $2000 Pension Income Tax Credit.  Alternatively, Rick can also convert some of his RRSPs to a RRIF or an annuity to generate $2000 per year of income which would also make him eligible for the Pension Income Tax Credit.

One couple with two pensions

Joanne and Steve are both retired teachers.  Steve has a bigger pension ($2800 per month) and continues to do some contract work on a part time basis.  When Steve adds up his income (Pension, CPP, and part time work), he is making about $65,000 per year and is in the 32% marginal tax bracket.  Joanne is making about $1900 per month from pension and $450 per month from CPP.  At $28,200 of income, Joanne is in the 25% marginal tax bracket.

Under the pension splitting rules, Joanne and Steve can give their spouse up to 50% of their pension for tax purposes.  It makes no sense for Joanne to move money from a lower tax rate to a higher tax rate.  It does, however, make sense for Steve to give some of his pension to Joanne.  If the next tax bracket is $42,707, then Steve can give Joanne $14,507 of his pension ($42,707 minus $28,200).  This moves money from a 32% tax bracket to a 25% bracket and saves them $1015 in taxes.  Steve is eligible to move up to $16,800 to Joanne but anything greater than $14,507 puts her into the 32% marginal tax rate.

Common law with no pensions

Zack is retiring at the age of 62 and never had a pension through work.  Instead, he contributed to a group RRSP and when he retires he figures he will need to generate about $2000 per month from a RRIF to supplement his CPP and some part time work he has lined up.  His wife Miranda did not work much and also has no pension.  She is currently collecting about $375 per month in CPP and does some freelance writing for about $500 per month.

Although Zack is in a higher tax bracket than Miranda, he cannot give any of his RRIF income to Miranda under pension splitting until the age of 65 because RRIF and annuity income does not qualify as eligible pension income until age 65.

One more case study

In case you need another example, CRA has a nice youtube video on Stu and Annabelle Johnson.

To get a full scoop on the administrative issues around pension income splitting, visit the CRA website.

Can you think of other circumstances where pension splitting makes sense?

New pension splitting rules were introduced in Canada in 2007 and in my opinion, it was one of the most significant tax breaks given to retired couples.

Income splitting is a great strategy to reduce taxes if you can move income from a higher income earner to a lower income earner.  An individual who makes $80,000 per year would pay considerably more tax than a couple that earned $40,000 each. There are three common income splitting strategies available for retirees:

1. Spousal RRSPs
2. CPP Splitting
3. Pension Splitting

What is pension splitting?

Pension splitting allows a spouse to give up to 50% of their eligible pension income to their spouse for tax purposes only.  There is no need to cut a cheque or give cash.  Pension splitting is a paper transfer done via the tax returns.

What is eligible pension income?

The most common form of “eligible” pension income is income from a registered company pension plan whether it is a defined benefit pension or defined contribution pension.

For those people who did not have a registered pension plan through work, they can take advantage of pension splitting by converting their RRSPs or deferred profit sharing plans into income through a life annuity or a RRIF.  Unfortunately, those individuals that do not have a registered pension plan, have to wait until after the age of 65 to split their pensions.

Income from Canada Pension Plan (CPP) and Old Age Security (OAS) do not qualify as eligible pension splitting.  CPP has it’s own set of rules for CPP splitting.

Who should take advantage of pension splitting?

There are three conditions to pension splitting:

1. You must be married or in a common-law partnership with each other in the year.  (You cannot be living apart for more than 90 days because of marriage breakdown).
2. You were both resident in Canada on December 31 of the year
3. You received eligible pension income

The general rule of thumb that I use to see if pension splitting makes sense goes something like this:

If the pension earner is in a higher marginal tax bracket than the spouse, then it makes sense to move money from a higher tax bracket to a lower tax bracket.

Taking advantage of the pension income tax credit

The Pension Income Tax credit is available to you if you are 55 years of age or older. Basically, it enables you to deduct, from taxes payable, a tax credit equal to the lesser of your pension income or $2,000.00.

If a spouse does not have pension income, the spouse with the pension should give the spouse without a pension a minimum of $2000 of pension income through income splitting so that the spouse can qualify for the pension income tax credit.  This effectively means the pension earner can get $4000 out of the pension without tax.

In the case of a two pension household where both spouses have pensions, they can’t each give the other $2000 to get $4000 of pension tax credits.  There is a limit of $2000 per person.

Having pension income does not automatically qualify you for the $2000 pension income tax credit.  You must claim the credit on line 314 of your tax return.

The paperwork for pension splitting

In order to take advantage of pension splitting, you have to complete Form T1032 – Joint Election to Split Pension Income.

Both spouses must sign the form.  It’s a pretty simple process so make sure you take a look to see if pension splitting will save you some tax.

To get a full scoop on the administrative issues around pension income splitting, visit the CRA website.

Old Age Security (OAS) and Canada Pension Plan (CPP) are hot topics because of all the attention on pension reform

• New CPP rules as of 2012
• Talk about the new Pooled Registered Pension Plans
• Will they change Old Age security?

From the questions I get, I realize many people are confused about the different government benefits so this article attempts to help people understand the differences between CPP and OAS.

CPP is not really a government benefit

One of the big differences between CPP and OAS is that the government does not fund CPP.  CPP is really a defined benefit pension plan, which is not part of government assets.  Canadians and their employers make contributions into CPP through their paycheques.

OAS on the other hand is a government benefit.  If you look at your paystubs, there is no OAS deduction.  Instead the income tax that Canadians pay go into a generally pot which goes to fund various programs, one of which is Old Age Security.

Will CPP and OAS run out of money?

Despite a common fear that CPP will run out, the CPP Investment board suggests that CPP is on solid ground because contributions into CPP have been steadily increasing and the plan continues to grow it’s reserves.  In fact new CPP changes came into effect in 2012 to provide greater flexibility for older workers to combine pension and work income if they wish; modestly expand pension coverage; and improve fairness in the Plan’s flexible retirement provisions.  All these changes are affordable under current funding levels.

Old Age Security is very different because there is no fund and there is no surplus.  OAS payments are paid by current taxpayers.  With all the baby boomers turning 65 over the next 20 years, the government is very concerned about the rising cost to fund OAS.  According to government reports, OAS is costing the government $36.5 billion dollars.  They predict that the cost to fund Old Age Security will triple to $108 billion by 2030.  Between CPP and OAS, OAS is more likely to be at risk of change.

Clawback

One of the questions I commonly get is whether CPP or OAS has a clawback provision. There is no clawback of CPP.  Clawback only applies to Old Age Security.  The OAS clawback means that high-income earners (over the age of 65) are required to repay some or the entire OAS pension.  If your net individual income is above a set threshold, your OAS pension will be reduced. Here are the starting thresholds:

• $69,562 for 2012
• $67,668 for 2011
• $66,733 for 2010
• $66,335 for 2009

As you can see, OAS is adjusted each year for inflation.

Age of eligibility

Canada Pension Plan is a benefit that defines ‘normal retirement’ as age 65.  You can take early CPP as early as age 60 but at a reduced rate.  You can also choose to collect CPP after 65 as late as age 70 at an enhanced amount.  There is some flexibility in when to draw CPP and there are mathematical breakeven points to consider.  Here’s a couple of article on on taking CPP early:

• The CPP breakeven points
• Should you take CPP early

Old Age Security is a benefit available at age 65.  You cannot collect OAS any early and there is no benefit to delaying the start of OAS after the age of 65.

One of the speculations from the Harper government is the change of eligibility of OAS from 65 to 67.  There has been some confusion and many people have mistaken this change to apply to CPP.

This is not the first time in OAS history that the government has tried to make changes to OAS. In 1985, Brian Mulroney tried to stop fully indexing OAS benefits to inflation.  In 1996, the Chretien government tried to replace the OAS program with a confusing and inferior Seniors Benefit.  In both cases, there was enough lobbying and backlash that the government backed off and left OAS alone.

Benefit amounts

The amount of Canada Pension Plan you will get in retirement is based on contributions into the plan.  The more you contribute, the more CPP you will be eligible for at retirement.  Here are the maximum benefits at age 65:

• 2012 – $986.67 per month
• 2011 – $960.00 per month
• 2010 – $934.17 per month
• 2009 – $908.75 per month
• 2008 – $884.50 per month
• 2007 – $863.75 per month
• 2000 – $762.92 per month

Old Age Security benefits have nothing to do with how much you worked, how much income you made or how much tax you paid.  OAS is based solely on residency.  If you were resident of Canada for 40 years between the age of 18 and 65, you will get the maximum OAS amount.  Here are the maximum OAS figures:

• 2012 – $540.12 per month
• 2011 – $524.23 per month
• 2010 – $521.62 per month
• 2009 – $516.96 per month

Survivorship

When someone dies, the Canada Pension Plan can continue to a spouse through a CPP Survivor Pension.  The surviving spouse must apply (it is not automatic) and the maximum combined CPP pension (personal CPP plus CPP survivor) cannot exceed the annual maximum benefit.

There are no provisions for OAS to continue to any after death.  OAS ends when the pensioner dies.

Splitting income

Couples can split their CPP retirement benefits. The only reason you would do this is if the spouse with the higher CPP is in a higher tax bracket than the lower CPP earner. Both spouses must be over the age of 60 and both have applied to collect CPP. CPP is a two directional split which means both spouses must split their CPP. For example, if the higher income spouse earns $700 per month and the other spouse earns $300 per month, CPP allows each spouse to take $500 per month ($700 plus $300 divided by 2).

There is no provision with OAS to split income.

My Two Cents

As you can see, Canada Pension Plan and Old Age Security are very different benefits.  Either way, its important to understand the benefits to see the role they will play in your retirement income plan.  Did I miss any differences?  Feel free to add in your two cents below.

Canada Pension Plan is one of those things that affect every working Canadian and yet it’s really misunderstood.

I was fortunate to be asked to talk about CPP and the new changes happening in 2012 on CBC Radioacross Canada.  The first station was in Windsor. I had to get up at 4:30am to start a 4:40 segment.  I then travelled (by phone) across Canada to talk to 8 different stations for 5 to 10 minute segments.  Thanks to Dagna, Tony Doucette in Windsor, Leigh-Anne Power in Gander, Matt Rainnie in Charlottetown, Terry MacLeod in Winnipeg, Joslyn Oosenburg in Yellowknife, Sandi Coleman in Whitehorse, David Gray in Calgary, Rick Cluff in Vancouver and Terry Seguin in Fredericton for having me on their shows today.

I thought I would share the questions and answers for anyone that might have missed it.

1. What are some of the key changes to CPP this year?

The most positive change is that it’s easier to get more.  Contrary to some people’s belief that CPP will not be there in the future, CPP is well funded and has been preparing for the eventuality that the boomers are all going to retire and drain CPP.  They’ve been building a surplus since 1996 and now have about $150 billion in assets and still growing.  Because of the surplus in CPP, it’s a little easier to qualify for maximum CPP because they can drop out more low-earning years from the calculation.  CPP will be there in the future.

Probably the most talked about change is the ability to take CPP early at age 60 without having to stop work.  In other words, you can be working at 60 and start early CPP if you want but at a reduced amount.  It used to be that in order to collect CPP, you had to STOP WORKING but they’ve eliminated that rule.

As a result, many more Canadians will be eligible to collect CPP early so to deter us all from taking CPP early, they are increasing the reduction for taking it early.  The reduction used to be 0.5% for every month prior to your 65^th birthday.  In other words if you were 60 years of age, 0.5% times 5 years times 12 months equals 30%.  At age 60, your CPP income would be 30% lower than your eligible amount at 65.  Under the new rules, they are going to increase the reduction from 0.5% to 0.6%.  That means instead of a 30% reduction at age 60, the reduction will be 36%.

In addition to trying to deter you from taking CPP at age 60, the new rules want to entice you to take CPP later after age 65.  If you decide to take CPP at age 70, they will enhance your CPP by 42%.  In other words, they are dangling this carrot at age 70 to see if you will give up income today to get more in the future.

The last change is the requirement to continue paying into CPP if you working. It used to be that if you were collecting CPP, you did not have to pay into CPP again if you started working again.  Now, all Canadians that work, have to pay into CPP but all contributions go towards increasing future CPP income.  If you work you pay.  If you pay, you will benefit.

2. Who should be paying most attention to these changes?

Because of the increased reduction from 0.5% to 0.6%, Canadians who are turning 60 to 64 this year should really pay attention to these changes because they have a big decision to make . . . Should you take CPP early and start your pension whether you are working or not.  Because they are phasing in the reduction over the next 5 years, waiting to take CPP may result in a bigger reduction.

The longer you wait, the more you will lose so you should really think about taking it early and at least run some calculations.

3. When would it make sense to taking it early or hold off on collecting CPP until age 70?

For me, the decision to take CPP early or leave it later is really about life expectancy and what I call the breakeven point.  Generally speaking if you think you are going to live a long life with a longer life expectancy then it may make sense to leave CPP till later.  Mathematically the breakeven point is between age 74 and 77.  If you can tell me EXACTLY when you are going to die then I can tell you EXACTLY whether you should take CPP early or leave it till later.  Here’s the breakeven calculation for 2012:

Generally speaking I think most people should and will choose to take it early but that’s a generalized statement that does not apply to everyone.  It’s important that you run some calculations and see what makes best sense for you.  Everyone’s situation is different but the math is the math.

4. Overall, are these changes beneficial? (Who wins and who loses out?)

With the new rules, there are both winners and losers.

Obviously one can argue that the people who lose out are the people who were going to retire before the age of 65 and take CPP early anyway. These people will face a bigger reduction under the new rules from 0.5% to 0.6% but at the same time, people who continue working also have the ability to keep paying into CPP to increase the future benefit.

People who were going to continue to work past age 60 now have the opportunity to collect CPP earlier without having to stop work.  That opportunity did not exist without having to stop work for 2 months.

5. What should people consider discussing with their financial planner in light of these changes?

CPP, OAS, and pensions are the foundation of retirement income because they have the ideal characteristics of retirement income – it’s guaranteed, consistent, increases every year and paid for life.

I’m always amazed at how many people have no clue how much CPP they are going get in retirement.  How can you properly plan for retirement income if you have no clue what you are going to get from CPP?  Some people qualify for the maximum benefit of $987 per month.  Others get a lot less.  The average is about $512 per month.  Everyone needs to call Service Canada and get his or her CPP statement of contributions.

This is a guest post from Cleo Hamel, Senior Tax Analyst for H&R Block Canada

According to recent Statistics Canada numbers, a 50-year-old worker in 2008 expected to stay in the labour force about 3.5 years longer than the same worker in the mid-1990s. But this does not mean we will enjoy fewer retirement years. In 2008, a 50-year-old man could expect to spend 48 per cent of his remaining years in retirement, compared to 45 per cent in 1977 because life expectancy has increased.

Many Canadians think that the Canada Pension Plan (CPP) benefits will replace any missing savings in their retirement years. It is not the case. The CPP is designed to replace about 25 per cent of your average pre-retirement employment earnings, up to a maximum amount. It will not keep you entirely comfortable in your golden years. But recent changes mean more flexibility for Canadians choosing to work a little longer.

Previously, CPP increased retirement pension by 0.5 per cent for each month you delayed the benefit after age 65. So, if you decided to take CPP at 70, your pension was 30 per cent more than it would have been if you took it at age 65. Under the new rules, that same delay will give you a 42 per cent increase. If you are between 65 and 70, still working and receiving CPP retirement pension, you will have the option of not contributing to CPP any longer. But any additional contributions would work to increase your monthly benefit.

Under the old rules, people between 60 and 65 who wanted to start receiving retirement pension early had to stop working for at least two months. It didn’t mean they couldn’t go back to work later but if they did, they didn’t have to resume contributing to CPP. This has changed as well. Now people no longer need to stop working in order to start receiving their retirement pension from CPP. However, if they do continue to work while receiving pension, they will have to continue making contributions. There is no option any longer. The good news is there is a benefit to paying more money into CPP. The additional contributions will increase CPP benefits as part of the new Post-Retirement Benefit (PRB).

But if you want to retire early, benefits are reduced. Under the old system, if you retired at age 60, your pension amount was 30 per cent less than if you had waited five years. Since January 1, 2012, the system will gradually change and the reduction will move from 0.5 to 0.6 per cent per month. It doesn’t sound like much but it means your pension would be reduced by 36 per cent, rather than the previous 30. The implication to your retirement plans depends on how much you plan to rely on your CPP benefit.

People out of the workforce for a number of years will also benefit under the new system. Now you can drop up to 7.5 years of zero or low income earning years from your benefit calculation. So, if you were a stay-at-home mom, family caregiver or you travelled for a period of time, those years can be ignored, resulting in a few extra dollars of CPP.

For more information about CPP, please see http://www.servicecanada.gc.ca/eng/sc/cpp/retirement/canadapension.shtml.