Taxes and Net Family Property Valuation of Pensions and RRSPs

August 2024

Introduction

Determining values of assets to be divided as part of a marriage breakdown is complex. Of course, so is the whole process of separation and divorce.  This article discusses how the taxable assets of defined benefit (i.e. lifetime) pensions and Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs) should be valued for use on the Net Family Property statement.  It also discusses the calculation needed when these assets are transferred as part of the equalization payment.

Clients and their lawyers often do not understand why income taxes must be considered as part of the valuation process.  Ignoring income taxes effects on certain assets can lead to costly errors and unfair settlements.  They also need to be considered in spousal support negotiations, but that is another topic.  Future taxes on other assets must also be considered in a similar manner to pensions and RRSPs, , such as capital gains taxes on real estate and investment portfolios.  Different tax rates and calculations may apply, and are not discussed in this article.  See my more detailed article, “Tax Calculations for Separation and Divorce.”

I often tell my financial planning clients, “Do not think that the $100,000 showing on your RRSP account statement is actually worth $100,000.” Everyone knows (or should know) that an RRSP withdrawal will result in a tax bill unless they have more tax deductions than income.  For the same reasons, income tax costs will reduce the values of assets when equalizing them upon your separation.

“Value” is seldom specifically defined in legislation.  However, valuation experts, such as Chartered Business Valuators, will tell you that value is the price that an asset would sell for in an open and unrestricted market where both buyers and sellers have a reasonable knowledge of the asset and the marketplace, are not subject to any undue pressure to buy or sell, are acting in their own best interest, and have a reasonable time period to complete the transaction.

For example, assume a husband and a wife have only two assets. The first asset is a bank savings account of $100,000 belonging to the husband.  I will use the bank account as an example, but it could be the family’s principal residence or other tax-free assets.  Assume that the second asset is an RRSP of $100,000 belonging to the wife.  It could also be a pension plan, real estate with large capital gains, or other taxable assets.  Next, let us consider income taxes.

The need for income tax adjustments

Is it fair to give the husband the bank account of $100,000 and give the wife the $100,000 RRSP? It certainly is not.  If the husband spends the money in the bank account tomorrow, he will have $100,000 to spend.  If the wife spends the money in the RRSP, she will first have income taxes to pay.  She will be left with much less money, typically only $60,000 to $70,000.  It will depend on her tax rate at the time of withdrawal.  Therefore, if you truly wish to equalize the assets, the husband must pay some money from the bank account to the wife to make up for this difference.  Once everyone realizes this problem, the question is, “How much must be paid to make up the difference?”  In a simple situation like this, it can be an easy calculation, as in the table below.  I am assuming the wife would pay 28% tax in this example.

A cash payment of $14,000 will make both parties “equal” based on values at the date of separation.

What tax rate should be used?

Choosing the correct income tax rate is important.  (The same rules apply to pensions and RRSPs, and I will use both terms throughout my examples.)  Certain professional advisors often use an arbitrary tax rate between 20% and 30%.  The correct rate would be the actual tax rate applicable at the time of withdrawal, which should be the obvious choice.  See my article, “Tax Calculations for Separation and Divorce” on more about determining the tax rate.

However, there could be more than one alternative. If it were known that the RRSP must be sold immediately to pay bills, then the person’s tax rate based on their current tax bracket should be used.  This would be the tax rate applicable on the next dollar of income earned, which is called the “marginal tax rate.”  Tax rates start out low, and gradually increase, such that the first amounts of income are always taxed lower than the later amounts.  Tax rates increase in steps (called marginal tax brackets) as income rises.

For example, assume a person over the age of 65 has taxable income of $50,000. They would pay taxes of about $7,500 based on Prince Edward Island 2024 tax rates (where I live).  Rates for other provinces will vary somewhat, usually a bit lower.  At $50,000 of income, they would be in a 28% “marginal” tax bracket.  This means that the next dollar they earn will be taxed at 28%.  However, if you do your math, you will note that $7,500 is only 15% of $50,000.  Their “average” tax rate on all of their income is 15%.  This is because they pay nothing on their initial income because of their personal tax credits, then they pay a low rate on some income, and they pay more tax on their income increases until it reaches their higher tax bracket of 28%.  However, overall, it averages out to 15%.

If the RRSP must be used immediately to pay for expenses, then a marginal tax rate of 28% would be an appropriate rate to use. In fact, the tax rate might be higher if the extra income will push them into an even higher tax bracket.  However, under normal circumstances, it would be expected that the RRSP would not be used until retirement age.  If that were the assumption (which is the normal scenario), then the average tax rate applicable to all income in retirement should be used.  This would be 15% in my example.  The marginal rate would not be appropriate because the RRSP should be treated no differently than any other retirement income, such as their income from Canada Pension Plan.  To determine the average rate requires a calculation of estimated retirement income.  This would include Old Age Security, Canada Pension Plan, pensions from employment, RRSP withdrawals and any other income.

Do you use the same or different rates for both spouses?

In many cases, I see the same tax rate being used for both spouses. This is certainly appropriate when both incomes are similar or taxable assets are small.  However, by way of another example, assume that both spouses have only two assets.  This time, each person has $100,000 in an RRSP.  Assume the wife has a retirement income, including RRSP withdrawals, of $50,000.  Her average income tax rate in PEI would be 15%.  In retirement, assume the husband will have a much higher taxable income.  If his expected income were $100,000, his average rate would be 28%, being higher than his wife’s tax rate.  For valuation purposes, her RRSP would be worth $85,000 ($100,000 less 15% tax).  His would be worth $72,000 (after deducting 28% tax).  Therefore, it would be unfair to say, “They both have equal RRSP’s, so we will let each keep their own RRSP and call it even.”  An after-tax equalization payment of $6,500 would be required by the wife to equalize their RRSP balances.  If the equalization payment is made by a bank account transfer of $6,500, both parties will have $78,500 as of the date of separation: the wife’s $85,000 minus $6,500 = the husbands $72,000 plus $6,500.

In many cases, all parties may agree that the difference created by using different tax rates is not material. In such cases, using the same rate will simplify the calculations and reduce professional fees.  However, such an agreement should not be made without due consideration of tax rate differences and the size of the assets.  This is especially true because some pension valuations for people nearing retirement may be near the million dollar mark.  In addition, differences in RRSP balances may be very high, which in themselves will trigger significant differences in retirement tax rates because of the required withdrawal rates when the RRSP is converted to a Registered Retirement Income Fund (RRIF).

What if the RRSP or pension asset is being transferred as part of the equalization payment?

However, what if the equalization payment is not made by cash, or by other non-taxable assets?  If, for example, the equalization payment is made by an RRSP (or pension) transfer, tax rates once again are important.  In order to receive an after-tax equalization payment of $6,500, the husband would expect to receive an RRSP transfer of $9,028  ($6,500/.72).  After he pays taxes in the future, he will only get $6,500.  On the other hand, in order to pay an after-tax equalization payment of $6,500, the wife would expect to pay an RRSP transfer of $7,647 ($6,500/.85).  This obviously does not work because the if the wife pays $7,647, the husband will only receive $5,506 after-taxes, not the $6,500 which is needed for equalization.  Conversely, if the wife pays $9,028, it will cost her $7,674 after taxes, which is more than the $6,500 that she owes him.  Either payment will still result in an unequal balance of net family property thanks to the Canadian tax system.  The resolution is to use the average of both of their tax rates – the average of 15% and 28% is 21.5%.  Note in Table 1 below that the equalization transfer of $6,500 is an after-tax amount, and $8,280 is the gross amount to be transferred, being $6,500 divided by (1.00 minus 21.5%).  Table 2 is the proof.

If $8,280.25 is transferred, and the NFP statement is re-done effective on the date of separation, the net assets are now equal, as demonstrated in Table 2:

The background for my tax adjustment opinions

Our goal is to equalize net family property as of the date of separation (or other valuation date as determined by the courts), not to give one person a preference over the other because of tax rates.  Income taxes are a real cost, and, although the future cannot be predicted with accuracy, reasonable assumptions are possible.  Discounting of the tax rate is not appropriate in this context because the RRSP and pension values are already discounted amounts if we use today’s values.  See further discussion in my article, “Tax Calculations for Separation and Divorce”

My theory, I believe, is consistent with the way taxes are calculated for defined benefit pension plans. The Standards of Practice (March 2013) published by the Canadian Institute of Actuaries, Standard 4320.27 states,

“Income tax may be taken into account in the calculation. If it is taken into account, then the actuary would do so by calculating the average income tax rate based upon the member’s anticipated retirement income computed in “current” dollars, including accrued and projected future pension income, Canada Pension Plan, Old Age Security and other anticipated income, and continuance of the tax environment at the report date or the calculation date; i.e., assuming continuation of the existing tax rates, brackets, surtaxes and clawbacks, applied to the projected income on retirement expressed in “current” dollars.”

In addition, in the Saskatchewan legal case of Knippshild v. Knippshild, 1995 CanLII 5840 (SK QB), Justice Kelbuc refers to Long v. Long [1989] W.D.F.L. 671 (Ont. H.C.) regarding a deduction for income taxes related to a pension valuation:

“In my judgment, the principles of fairness and equity require that a deduction for tax obligations be made even though the Plan cannot be collapsed immediately. As to the discount rate, I am of the view the procedures as set out in Long v. Long [1989] W.D.F.L. 671 (Ont. H.C.) are applicable. They are:

• when a court is satisfied as to when sheltered funds are to be collapsed, the tax deduction to be allowed should be the rate at which the owner would, in that year, be taxed, bearing in mind the sum total of all income including the face value of the R.R.S.P.’s for the given tax year.

• when a court is not so satisfied, they should be discounted at the minimum income tax rate then applicable, UNLESS;

• unusual and special circumstances warrant otherwise in which case a notional discount could be given depending on the unusual and special circumstances that might weigh in favour of this option.”

Conclusion

I hope this article, though complex, helps shed some light on the importance of considering income taxes in reaching asset valuations if a fair equalization of assets is intended. It also likely suggests the importance of using skilled financial advisors and legal counsel.

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Blair Corkum, CPA, CA, R.F.P., CFP, CFDS, CLU, CHS holds his Chartered Professional Accountant, Chartered Accountant, Registered Financial Planner, Chartered Financial Divorce Specialist as well as several other financial planning related designations. Blair offers hourly based fee-only personal financial planning, holds no investment or insurance licenses, and receives no commissions or referral fees. This publication should not be construed as legal or investment advice. It is neither a definitive analysis of the law nor a substitute for professional advice which you should obtain before acting on information in this article. Information may change as a result of legislation or regulations issued after this article was written.©Blair Corkum