Note: For non-registered funds, tax can be withheld but it must be a flat amount. For all other sources of funds, tax or additional tax can be withheld and can be a percentage or a flat amount.
Taxation of non-residents
When the policyholder of a payout annuity becomes a non-resident, we base their non-resident withholding tax on the source of funds used to purchase the annuity and the policyholder's country of residence, provided that the client supplies us with an NR301 form Declaration of Eligibility for Benefits Under a Tax Treaty for a Non-Resident Taxpayer. If we do not have this form, the government requires us to withhold 25 per cent.
For a deferred annuity, no tax form is issued during the deferred period. Once payments begin, Canada imposes a withholding tax.
Pension income: Eligible income, tax credits and income splitting
Income that qualifies as "eligible pension income" can receive preferential tax treatment.
Annuity income that qualifies as pension income:
The age of the annuitant determines if their income qualifies as eligible pension income, regardless of the premium source. Income for annuitants under the age of 65 does not qualify as eligible pension income. Income for annuitants age 65 and over qualifies as eligible pension income.
Pension income tax credit
A taxpayer can claim a federal tax credit on up to $2,000 of eligible pension income. As well, most provinces offer a tax credit on eligible pension income.
Pension income splitting
A taxpayer can transfer up to 50% of eligible pension income to their spouse. This transfer is for income tax purposes only and it does not transfer ownership of the income to the spouse. Because the transfer can result in an increased tax liability for the spouse, both the taxpayer and their spouse must file a special election form with their annual tax returns to allow this transfer.
Pension splitting can result in significant tax savings for a taxpayer and their spouse:
- Transfer income from a higher-income spouse to a lower-income spouse.
- If the receiving spouse does not have other eligible pension income, it allows the couple to claim an additional pension credit. This is an advantage even if both spouses have the same tax rate.
- If the transferring spouse has net income above the Old Age Security (OAS) clawback amount, pension income splitting with a lower-income spouse could reduce or eliminate the clawback, keeping more money in their pocket.
An example of the benefits of creating eligible pension income
Jim, age 70, lives in BC. His marginal tax rate is 32%. His wife Karen has a lower marginal tax rate of 20%. Jim currently does not have any eligible pension income. If he buys a life annuity using $500,000 of his non-registered savings his:
- Annual income is $45,514,
- Of that income $9,800 is taxable,
- The $9,800 is eligible pension income so,
- he can allocate $4,900 to Karen for tax purposes.
- they both can claim pension income credits of $2,000 of pension income, saving each of them up to $300 in federal tax credits and $51 in provincial tax credits.
Avoiding OAS clawback
If a taxpayer's taxable income is too high, some government benefits may be reduced or not available. Or, the taxpayer may not qualify for some income-tested tax credits.
Investment income is included in taxable income at different rates. For example, interest income is included on a tax return at 100 per cent, and dividend income is "grossed up" before it's included in income. For income from a prescribed annuity (non-registered), only a portion of a payment is taxable and the taxable portion is the same every year.
A client may be able to restructure their investment portfolio to reduce their taxable income by using some of their assets to purchase a prescribed payout annuity. The client can maintain a desired level of income but reduce taxable income, which will allow them to avoid the clawback or disqualification from some benefits or credits.
Potential creditor protection
If the annuity is purchased with locked-in money, the contract and the income may be protected from creditors based on applicable pension legislation.
If the annuity is purchased with non-locked-in money, during the guaranteed period, the contract and income may be protected if there is an appropriate family or irrevocable beneficiary designation.
