The advantages of spousal RRSPs
By Peter Diekmeyer • Bankrate.com

Most Canadians know Registered Retirement Saving Plans are one of the best tax-deferral strategies around. But the lesser-known spousal RRSPs take those advantages several steps further.

Spousal RRSPs are just like regular RRSPs, with the key exception that contributions are made by the higher income spouse into the lower income spouse's plan.

If the lower income spouse already has an RRSP, a separate plan must be set up for the contributions made by his or her spouse. That's because the rules governing the withdrawal of contributions from spousal plans are different from those for conventional plans.

The benefits of a spousal RRSP
A spousal RRSP brings significant benefits to the contributor and the beneficiary. These benefits include income-splitting opportunities and the ability to maximize key deductions and reduce the effects of claw-backs from various means-tested programs.

The most immediate tax saving opportunity occurs when contributors put money into their spouses' plans.

The contributor is generally the higher income spouse. Men still generally earn more than women in Canada and thus contribute more to spousal RRSPs. Since he is typically in a higher tax bracket, he gets a larger tax refund than his spouse would if she had made the contribution herself.

Income splitting
Spousal RRSPs also bring big advantages when the money is eventually withdrawn from the plan upon retirement.

For example, if two spouses withdraw $30,000 a year each from their RRSPs, both benefit from the lower tax rates at the lower income brackets, while a single spouse who withdrew $60,000 a year would be propelled into a higher bracket.

"The ideal is that you should plan your retirement so that both spouses have similar income levels," says Evelyn Jacks, a tax expert and author of "Tax Savings for the Long Run."

The benefits of spousal RRSPs go beyond lower tax rates, she says.

"If two spouses have RRSPs, then both can benefit from the nonrefundable pension tax credit," says Jacks. "That works out to 16 percent of the $1,000 base amount, plus amounts provided at the provincial level that differ based on where you live."

Splitting income by setting up a spousal RRSP can also help reduce or even eliminate the Old Age Security (OAS) claw-back, which currently kicks in when your annual income hits $59,789.

For example, one spouse with $100,000 in annual income would have a significant portion of his OAS payments clawed back, while two spouses with $50,000 a year each in income would have nothing clawed back.

Potential pitfalls
The biggest pitfall of a spousal RRSP is the lower income spouse must wait three years after the last contribution was made to her plan before she can withdraw the money. Otherwise, certain income-attribution provisions take effect.

That rule came about because the federal government wanted to prevent couples from setting up a cycle whereby one person contributed to the other's plan, benefited from the deduction and the following year, the other spouse would withdraw the money at a lower rate.

To prevent such a cycle, the rules state that the contribution portion of any withdrawals made from a spousal RRSP within the mandated three-year waiting period are attributed back into the taxable income of the contributor.

However, the interest earned during that time would be taxed in the hands of the spousal plan holder. That means if you need to get your money of the spousal plan in a hurry, you could pay a significant tax penalty.

Jacks suggests there are ways to minimize the damage -- for example, by taking out half of the early withdrawal amount in December of one year and the other half in January of the next year.

That way, the income tax paid is split between two taxation years and the separate withdrawal amounts may fall in lower tax brackets than if they were combined.

One pitfall that you need not worry much about is the case in which one spouse contributes to another's RRSP for many years, and then they become divorced, says Jacks.

"The assets are split 50-50 in most divorce cases these days," she says. "And the courts make special provisions when RRSPs are transferred as a result of a divorce, so the plan does not have to be collapsed."

How to set up a spousal RRSP
Setting up a spousal RRSP is as simple as setting up a regular plan. Any major financial institution will be glad to help.

Just make sure that if your spouse makes contributions to your plan that you keep these amounts separate from the contributions you make yourself.

And keep track of them, especially in cases where you think an early withdrawal might be in the cards, because you don't want to be hit with the attribution rules.

Peter Diekmeyer is the Montreal Gazette's management columnist.