Pension splitting...a significant step in the right direction?

In today's media-rich and highly politicized environment, truly assessing the merits of new legislative decisions becomes difficult at best. Should you then consider the emotional confusion that financial considerations bring, a clear vision for discerning advantages from disadvantages begins to approach a description somewhere close to "bleak"? While the timing and motivation behind Jim Flaherty's (Federal Finance Minister) recent announcement may be in question, what is not in question is the fact that the newly-publicized measures have evoked much emotion, confusion, and general controversy. That being said, the purpose of this article will be to, essentially, remove the emotional and political overtones associated with the income trust taxation issue, in order to focus more clearly on the actual benefits that the allowance for income splitting will bring to pensioners now and into the future.

The above-mentioned announcement by the federal government stipulates that, starting in 2007, pensioners in Canada will be able to split income from corporate pension plans; similar to the way in which they are able to do so for the Canada Pension Plan. Depending on the source of one's information, such a move will potentially benefit anywhere from nine hundred thousand to in excess of two million Canadians - a noticeable impact by either count. A fair assessment, however, of what that impact might be at an individual, or family level, is where the true value resides. Such a determination requires a review of some of the underlying principles.

The term "income splitting", is used to describe strategies for shifting income from higher tax bracket family members to lower tax bracket family members. Due to the progressive nature of Canada's tax system (i.e. marginal tax rates increase as taxable income increases), such a shift effectively allows a greater portion of the family income to be taxed at a lower rate, thus allowing for tax savings, and a corresponding higher level of after-tax income for the individual and/or family. To date, the federal government has had in place a number of rules to prevent income splitting in many situations. Referred to as "attribution rules", these stipulations serve to prevent the tax-advantaged shifting of assets described above. More specifically, these rules state that when you transfer income-producing assets to another family member, the income and/or capital gains earned on the transferred asset will be attributed to, and taxed in the hands of, the transferor. Restrictions of this variety have provided significant challenges for those families where, for a variety of reasons (i.e. one spouse stayed home to raise children), one spouse earns significantly more than the other.

To further clarify the above point, one could consider two retired couples; each possessing total household income of $62,000. If one household had two incomes of $31,000, while the second household experienced disproportionate incomes of $51,000 and $11,000; the result would be an unfortunate after-tax disadvantage of $2,400 per year for the latter couple! Such a reality has given rise to the term "single-income penalty"; alluding to the extra tax paid by the household with dissimilar incomes (due to the higher tax rate applied to the $51,000). In short, an income-splitting situation would save the second couple $2,400 a year in taxes ... the true value mentioned earlier!

While such an example does help to crystallize what is potentially the most noteworthy advantage of pension splitting, it must be remembered that there will still be a number of seniors whose tax burden will not be reduced to any great degree, if at all, by such a softening of the attribution rules. Specifically, pensioners that are single, couples with commensurate pensions, and households where each spouse has more than $118,000 of income, or less than $30,000 of income. In addition, new realities will almost certainly reside in situations characterized by reduced usefulness of spousal RRSPs, lessened inequity between defined benefit plan members and defined contribution or RRSP contributors, a leveling of the playing field between those who divorce and those who remain married; not to mention a wide-ranging simplification of the financial planning process as a whole.

Having addressed some of the functional merits of the proposed pension splitting legislation, it must also be mentioned that the Federal Finance Minister also indicated the government's intention to retroactively (as of January 1st, 2006) raise the Age Credit Amount by $1,000 to $5,066. For those 65 and older, who qualify for the full credit, an extra $152.50 in tax savings should be generated for 2006. Clawback of this benefit begins at a net income of $30,270, and reaches a point of being fully clawed back at $64,043 - up from $57,377 prior to the increase of the Age Credit.

All told, beyond the initial trauma of a near-term dive in the income trust sector, much of the newly-publicized measures should play to the advantage of a significant number of pensioners in Canada. The degree of benefit for any given individual or family, however, will quite probably vary to a noticeable degree, and should be discussed at some length with a trusted Financial Advisor or Planner.