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The pension income tax credit: One benefit of opening a RRIF early

Older man playing the guitar in his house

As a physician, it’s likely you won’t have much, if any, income from a pension plan in retirement. But you may still have income that is eligible for the pension income tax credit. With some smart tax planning, you can take advantage of this tax credit to reduce your household tax bill.

What is the pension income tax credit?

If you have up to $2,000 of “eligible pension income,” you can claim a federal tax credit that will reduce your tax payable on that income by 15%. On $2,000, that’s a savings of $300.

Eligible pension income generally includes income from:

  • annuities
  • Canadian registered plans, e.g.
    • registered pension plans
    • registered retirement income funds (RRIFs)
  • foreign pension plans
  • pension income transferred from a spouse

Eligible pension income does not include:

  • Old Age Security benefits
  • Canada Pension Plan/Quebec Pension Plan benefits
  • retiring allowances
  • death benefits
  • payments from a retirement compensation arrangement
  • amounts withdrawn from an RRSP

Note that the pension income tax credit is “non-refundable,” meaning you won’t be able to use it if you don’t have any tax payable (the credit can only reduce your liability to zero). Also, you also can’t carry forward the credit to use in a future year.

There are also provincial pension income tax credits, in all provinces and territories except Quebec, that can provide further tax savings on eligible pension income.

Early RRIF withdrawals qualify for the credit

If you’re age 65 or older, income from a RRIF is eligible for the pension income tax credit. This means that if you or your spouse have an RRSP, reaching age 65 opens up a tax planning opportunity.

Here’s how: At age 65, you can convert some of the funds in your RRSP to a RRIF, then make withdrawals from the RRIF, which qualify for the credit. Although you’re required to convert your RRSP into a RRIF no later than the end of the calendar year in which you turn 71, you can do so earlier — which allows you to make RRIF withdrawals that are eligible for the pension income tax credit.

It’s important to realize that the 15% federal pension income tax credit alone is likely not reason enough to convert your RRSP early. However, early conversion can have other benefits as well, especially if your RRSP is large. So if you are withdrawing from your RRSP early, you may want to consider this strategy.

The strategy in action

Here’s an example of how this strategy could work in practice.

  • Dr. Schuett, a Winnipeg internist, has just turned 65 and has $1 million in his RRSP. His spouse, age 63, has her own RRSP as well.
  • Dr. Schuett’s financial plan involves starting to withdraw from his RRSP early. In order to do so, he opens a RRIF at his financial institution and transfers $12,000 from his RRSP account to the new RRIF account, leaving the remaining balance of $988,000 in his RRSP.
  • From his new RRIF, Dr. Schuett withdraws $2,000 each year, creating the maximum pension income that’s eligible for the pension income tax credit. At tax time, he claims the pension income tax credit on this income, saving him $300 in federal income tax and $108 on his provincial (Manitoba) taxes.
  • When his spouse turns 65, she follows the same process to open a RRIF and withdraw funds eligible for the tax credit. Together, they can save $816 a year in taxes.
  • By the time Dr. Schuett is 71, he has withdrawn all of the $12,000 originally transferred to this RRIF account. At the end of the calendar year in which Dr. Schuett reaches age 71, he converts the balance in his RRSP to a RRIF. From age 72 onward, withdrawals from that RRIF are also eligible for the pension income tax credit.

Income splitting can reduce taxes on your RRIF withdrawals

By converting part of his RRSP early, Dr. Schuett has created seven extra years in which he has income eligible for the pension income tax credit. Following the same process, his spouse has also created extra pension income tax credits, from age 65 to 71.

The couple can use the withdrawn funds in any way that they choose. For example, Dr. Schuett could contribute the withdrawn amounts to a tax-free savings account or even back to his RRSP, as long as he has RRSP contribution room.

The couple’s RRIF withdrawals are also eligible for pension splitting, should they elect to do so, in which up to 50% of the withdrawn amount is taxed on your spouse’s income tax return.

If Dr. Schuett’s tax rate is higher than his spouse’s, pension splitting would allow the couple to reduce their household income tax bill. For example, let’s assume that Dr. Schuett would pay income tax at a rate of 50% on the funds withdrawn from his RRIF, while his spouse’s tax rate is 25%. By allocating $1,000 of his $2,000 RRIF withdrawal on his spouse’s tax return, the household will save an additional $250 in tax each year.

By combining the two strategies of creating income eligible for the pension income tax credit and pension splitting, your tax-smart household can potentially save thousands of dollars in tax. In consultation with your accountant, your MD Advisor* can help you develop a specific plan to create tax savings using these strategies.

*MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.

The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.