Potential Tax Traps in Separation/Divorce

July 29, 2022
Scattered U.S. and Canadian currency, representing cross-border tax implications of separation and divorce

Mark Feigenbaum

This article originally ran on July 14, 2022, in The Lawyer’s Daily online.

Hearing about the computation of taxes doesn’t usually bring tears of joy to most lawyers. Still, for a family lawyer, it is prudent to take a minute and ensure that the correct tax calculations are used during the financial calculations. It may have an impact on either party in the equalization.

It is common to use a flat 25 per cent tax rate during equalization or for other purposes. Without being sure of the historical significance of that, considering the rates change constantly, we need to drill down and get closer to the actual current and predicted rates — especially when large dollar amounts are involved.

Spousal RRSP withdrawals made by, and taxable to, the spouse

Let us use registered retirement savings plans (RRSPs) as an example, as this asset has significant tax consequences when it is ultimately paid out. These plans can be self-administered with allowable assets or purchased from a financial institution.

An RRSP is a deferred tax plan. A contributor to the plan can claim a tax deduction for the contribution to their own or spousal RRSP within a limit that is the lesser than the RRSP dollar limit, which is $29,210 this year or 18 per cent of earned income from the previous year, less any adjustment if there is also another pension plan. This deduction limit can carry forward if unused and is called the “deduction room.” If a contribution is made beyond this deduction room, a severe penalty of one per cent a month is assessed for the excess contribution.

A contribution can also be made to a spousal RRSP as long as the total contributions don’t exceed the entire individual deduction room of the contributing spouse. Withdrawals from this spousal RRSP are made by, and taxable to, the spouse. Here is our first landmine in family law equalization, as this spousal RRSP asset is now considered owned by the spouse.

Spousal RRSP withdrawals must be addressed in equalization

The magic of the RRSP is that you get a deduction for the contribution, and any growth within the RRSP is not taxed at the time earned. You can withdraw at any time from the RRSP, and the entire amount withdrawn is included in income. With the spousal RRSP, it is withdrawn by the spouse and included in their income unless it is withdrawn within three years of contribution.

The strategy is to obtain a deduction when the marginal tax rate is higher than when the withdrawal is included in income, usually when there is lower taxable income in retirement. Similarly, a spousal RRSP is used when the spouse is expected to have low taxable income in their retirement. The payment can be withdrawn from both the regular and spousal RRSPs simultaneously and taxed at the lower marginal rates (which is the tax on the next dollar of income) in both individuals’ tax returns.

Withdrawing or transferring the RRSP to anyone (except in the case of separation/divorce) causes the amount to be included in income. This is the tax issue that needs to be addressed in equalization.

Timing of withdrawal can have significant tax implications

In Ontario, for instance, the top marginal rate is 53.53 per cent on income over approximately $222,000. The rates are from 15 per cent on about $15,000 to 48 per cent on income between roughly $155,000 and $220,000.

This is a wide range, and a flat rate of 25 per cent may not fit every category. This is also the marginal rate, the tax on the next dollar. Looking at the average instead of marginal rates, at $50,000 of income, the average rate is 15 per cent; at $100,000, the average rate is 23 per cent; even at $222,000, the average rate is about 35 per cent.

Using an example of a $25,000 RRSP asset, the parties are residents in Ontario. In this example, the assumption will be that the RRSP needs to be withdrawn to pay the equalization or other debt, and the individual has an additional $50,000 of employment income that year. The tax on the first $50,000 is about $7,500 (15 per cent), and the additional rate on the extra $25,000 RRSP income is about 30 per cent. Those numbers skew greatly depending on the taxpayer’s other projected income and total income, including the RRSP withdrawal.

On the other side, let’s assume they won’t be taking the RRSP out until their retirement and then at $10,000 per year for five years. Then the tax may well be $0 or even $1,500 per year, nowhere close to 25 per cent in total.

Depending on circumstances, flat 25 percent tax rate assumption may be to spouse’s detriment

There is an option of transferring the RRSP directly to the spouse as part of the equalization. Their projected income may differ significantly, and the ultimate tax paid on their withdrawal provides planning opportunities to reduce the taxes on the RRSP and create a different net equalization result. And don’t forget the spousal RRSP, which may need to be equalized backwards to the contributing spouse.

This doesn’t even consider whether the payor or recipient spouse is a U.S. citizen, green card holder, or resident when taxes in the other jurisdiction must be considered.

In short, considerable attention must be paid to assets with tax implications, like in our RRSP example. A flat 25 per cent tax rate assumption may be to the detriment of your client and may not generate an accurate equalization calculation.

Feigenbaum Consulting Provides Comprehensive Family Law & Tax Services

Family law disputes pose distinctive and substantial risks to professionals, business owners, and high-net-worth individuals. Feigenbaum Consulting offers multi-faceted advice and legal solutions that consider all financial and tax implications relating to separation, divorce, and division of property. As a lawyer and accountant in both Canada and the U.S., Mark Feigenbaum is uniquely positioned to provide this comprehensive approach to complex family law matters.

Located conveniently just outside of Toronto, Feigenbaum Consulting serves clients in Canada, the United States, and across the world. To book a consultation on your family law matter, contact the firm online or by phone at 905-695-1269 (toll-free at 877-275-4792).

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