Last week we learned that RRSPs are a great tool for retirement saving in many circumstances. However, retirement isn't the only smart way to use RRSPs. They can also be used very effectively for income splitting and tax saving when planning a family. For many Canadians a traditional life cycle goes something like this. Go to college, get a job, find your true love, spend some time together, start a family, struggle financially, get older, save some money, etc.
Talking to my friends, one of the hardest decisions for moms is the decision of going back to work after having a baby. Like it or not, finances are a key factor in this decision and may essentially "force" mom or dad to go back to work. If this sounds like you, there's a great way to save money on taxes and set up a tax-efficient income stream for the stay-at-home parent. I'll call it the RRSP Baby Fund and it works for moderate to high income couples—with RRSP accounts. (The higher the income the bigger the benefit.)
Using Spousal RRSPs for a Baby Fund
We know standard RRSPs are tax deferral accounts where the contributor is able to deduct contributions from their taxes now, but must pay income tax on withdrawals later. Spousal RRSPs are similar, but contributions made by you are designated to benefit your spouse (or common-law partner). You claim the deduction, get the tax refund, and lose the "RRSP room", but your spouse gets to withdraw the money and pay taxes at their income level later.
Withdrawals from a Spousal RRSP are reported on your spouse's tax return *if no contributions were made to the Spousal RRSP account in the tax year of the withdrawal and the two years preceding the withdrawal*. If you have time to plan in advance, a couple could shift income from high earning working years to those low earning childcare years and from one spouse to the other.
Take Note: If you're using this strategy it's important to reduce your portfolio volatility because your investment timeline is shorter. You should have no more than 50% stocks in your account.
Example Case Study
Doug and Kaylee are 24 year old college sweethearts in Ontario. They graduated last year, are in a common-law relationship, and both found good jobs that pay $60,000. They can each contribute a maximum $10,800 (18% of income) to RRSPs. They are both currently in the 29.65% tax bracket so for every $100 dollars they contribute to RRSPs, they reduce their taxes by $29.65. Their plan is to have at least 2 children, have their first when they turn 30, and Kaylee wants to take leave from work until their second child goes to Kindergarten when she's 37. They heard about the RRSP Baby Fund so they put it to work.
Kaylee will get 1 year of EI maternity leave, so Doug can only contribute for 4 years to keep the 3 year buffer (so the Spousal RRSP withdrawal gets claimed on Kaylee's return, not his). Kaylee maxes out her RRSP contribution each year for the whole period; she's contributing to her personal RRSP so she doesn't need to wait to make withdrawals and can use any excess money for retirement.
By age 30, Kaylee will have $74,230 in her personal RRSP if she contributes $900/month for 6 years in a more cautious portfolio returning 4.5%. If Doug contributes $900/month for 4 years to a Spousal RRSP benefitting Kaylee and then let's it ride with no new contributions, the Spousal RRSP will have $51,675. They won't make withdrawals from any account during the first year of Baby 1 because Kaylee will get EI, so the accounts grow to $77,570 (Kaylee RRSP) and $54,000 (Spousal RRSP). Because there were no contributions to any Spousal RRSP for 3 years, Kaylee can start claiming withdrawals from the Spousal RRSP as her income when she turns 31 and needs to make the money last 6 years until she goes back to work.
Annual Spousal RRSP withdrawals will be $10,450 each year to deplete the account and personal RRSP withdrawals will be a max of $15,040. Let's assume they need to make the max withdrawals to pay for all those diapers and formula—Kaylee's taxable income is $25,490. Her net income after the Child Benefit maxes out at $27,822 after the second child.
The tax rate on Kaylee's RRSP withdrawals is ~14%. Big difference from the 29.65% tax refund on contributions!
Here's a visual of this strategy:
What if they had just put the money in a regular investment account (normal baby fund)? Their contributions would be reduced to $7,600 per year each because they wouldn't receive the $3,200 tax refund. All other factors identical, by the time Kaylee needed the money at 31 years old, the account would be worth $92,540. This will allow max account withdrawals of just $17,940 per year if they want to money to last 6 years.
Although the RRSP contributions were made on moderate $60,000 incomes, they are way better off using the RRSP Baby Fund method because the tax rate on withdrawals is so low.
Smart tax planning strategies like this could mean the difference between staying home with the kids, or having to go to work and putting the kids in a germy daycare.
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