Using the Pension Income Tax Credit
After a working career of three or four decades or more, you hope you have put away an adequate amount of money in your employer pension plan and/or your RRSP so that you can live an adequate lifestyle in retirement. You are concerned, however. Living off those accumulated assets may be more of a challenge than you had anticipated. Fortunately, the government is equally concerned and has provided a tax credit that allows you to reduce the tax on the amount of your pension. If you are married, you can share your pension with your spouse, too, potentially further reducing your taxes.
How much is the tax credit?
The tax credit is based on a maximum of $2,000 in eligible pension income. To be clear, this is a tax credit and not a tax deduction. The latter reduces your taxable income, while the former reduces your taxes.
To calculate your tax credit at the federal level, you take $2,000 of pension income and multiple it by 15%, which is the lowest federal tax rate. $2,000 x 15% = $300. Your taxes are reduced by $300.
The maximum eligible pension income varies by province. In Ontario, the maximum is $1,541. The lowest provincial tax rate in Ontario is 5.05%. Multiplied by $1,541, your tax credit is $78. For other provinces or territories, you can find the maximum qualifying amounts here, and the maximum credits here.
If we stay with Ontario for the moment, this means the total credit available to you is $378 ($300 + $78).
Note that this is a non-refundable tax credit, which means that you can only use the credit to the point that your taxes go to zero. An example of a refundable tax credit is the GST/HST credit.
What kind of pension income qualifies and when do you qualify?
Less than age 65
Defined Benefit Pension Plan
If you have a defined benefit pension plan, your pension income qualifies no matter the age at which you start to receive it.
Foreign Pensions (including US Social Security)
Because of treaty arrangements, certain portions of foreign pension income may be deductible and, therefore, tax-free in Canada. These tax-free portions are not eligible for the tax credit. Only amounts that are taxable in Canada qualify for the tax credit.
Several Other Benefits Received as the Result of the Death of Your Spouse
Among the qualifying types include income from Deferred Profit-Sharing Plans (DPSP), regular annuities, RRIFs, or RRSPs. Note that withdrawals from an RRSP do not qualify. It must be “income” in the form of an annuity bought with assets in an RRSP.
Age 65 or older
The conditions required to qualify for the pension income tax credit if under age 65 no longer apply once you reach 65.
Canada Pension Plan (CPP)
Despite being called a pension plan, you cannot claim the tax credit on income from CPP.
Old Age Security (OAS)
OAS is also ineligible.
Just to make it clear, RRSP withdrawals, other than annuity payments, are not eligible.
Also ineligible are death benefits, retiring allowances, payments from salary deferral arrangements, retirement compensation arrangements, employee benefit plans, or employee trusts.
An opportunity to split income
Up to 50% of eligible pension income may be split with a spouse or common-law partner. If for example, you are receiving income from a defined benefit pension plan, you can split a portion of your income with your spouse at any age. If your pension income qualifies because you are over age 65, you can also split your pension with your spouse if your spouse would have qualified for the credit if receiving the pension directly rather than through you.
This is a tax planning opportunity in that your income is reduced while the income of your spouse increases. There may be circumstances in which it does not make sense to do this. If your spouse is earning more income than you, then reducing your income tax payable while increasing your spouse’s tax may not be the best choice, even if your spouse can use the tax credit.
Taking advantage of the credit in the year you turn 65
In the year you turn 71, you are legally obligated to do one of three things to your RRSP: 1) collapse it, withdrawing the entire balance and thereby exposing the entire balance to tax at your marginal tax rate; 2) purchase an annuity, essentially turning it into a pension so that you receive regular payments for the rest of your life; or 3) transfer it into a Registered Retirement Income Fund (RRIF), from which you will begin making mandatory Annual Minimum Payments (AMP) in the year your turn 72.
However, you do not need to wait until 71 to convert your RRSP into a RRIF. With the Pension Income Tax Credit in mind, you can begin doing so in the year you turn 65. For example, in the year your turn 65, you can transfer $12,000 of your RRSP into a newly opened RRIF and take $2,000 per year from that RRIF in that year and each of the following five years, claiming the tax credit each year. If your spouse is also 65 and lacks other qualifying pension income sources, you can transfer a larger amount into your RRIF, split the withdrawal with your spouse, and each claim up to $2,000 per year. In Ontario, over six years that is $2,268 in tax savings, doubled to $4,536 for a couple.
However, if you are already receiving qualifying pension income that pays you greater than $2,000 per year, you have already met the threshold for maximizing the tax credit. This strategy, therefore, works best for those without other sources of qualifying pension income.
This is the 124th blog post for Russ Writes.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.