Mr. and Mrs. Smith have decided to get a divorce. When couples end a marriage, an equalization payment is required that considers the value of their matrimonial assets. Mrs. Smith’s RRSP portfolio statement says her RRSP is valued at $1 million. But how much is her RRSP worth for matrimonial equalization purposes?
It is important to remember that an RRSP is a tax-deferred savings vehicle which is taxed on the withdrawal of funds, typically during retirement.
Having $1 in an RRSP is not equivalent to $1 in a bank account.
We usually discount the RRSP by a factor typically between 10 per cent to 30 per cent to account for the contingent income taxes. The discount factor is impacted by two main factors: (1) the effective tax rate of the RRSP holder during retirement, and (2) when the taxes are going to be paid. We refer to the taxes as contingent, as they are not owed until the funds are removed from the RRSP.
How does the tax rate affect the contingent taxes on Mrs. Smith’s RRSP?
When the funds from the RRSP are removed, they are taxed as ordinary income. Tax rates are progressive — the more income you make, the higher the tax rate.
Our task is to forecast Mrs. Smith’s income and, therefore, her tax rate during retirement, which will include determining her sources of and the level of income. If she is like most people, she will have a lower income after she stops working.
How does the expected time of removal of the funds affect the contingent taxes on Mrs. Smith’s RRSP?
In order to pay the taxes that will be payable upon the future removal of funds from the RRSP, we must determine how much to put aside at the date of separation.
We know that Mrs. Smith must convert her RRSP to a RRIF or annuity at the latest when she is 72 (the date of her first dollar from retirement income), and the actuarial tables tell us her mortality is age 85 (her last dollar of retirement income). The convention is to look at the midpoint between these dates as the expected removal date; therefore, we can assume her average dollar comes out at age 78.5. If Mrs. Smith is 50, that midpoint dollar will come out 28.5 years from now.
Of course, few people are average, so we look at the relevant facts on a case-by-case basis. If Mrs. Smith has evidence that she was planning to retire earlier or withdraw from her RRSP other than at retirement, we adjust the timing accordingly.
What is the value in today’s dollars of the contingent taxes on Mrs. Smith’s RRSP?
Now we know the RRSP’s value at the date of separation, the expected tax rate and the RRSP withdrawal timing. If these contingent tax dollars will not be paid until withdrawal in, say 28.5 years, we discount to arrive at the amount in today’s dollars.
Then the question becomes how much to put aside to meet Mrs. Smith’s future tax obligations.
If Mrs. Smith will owe $100 in tax on her RRSP, she will not need to put aside $100 to make the payment. Rather, she will need to put aside the amount of money that will grow to $100 at the time of payment. Due to the time value of money, if Mrs. Smith’s retirement (and the start of her tax obligations) is five years from now, we must put aside more money than if her retirement is in 28.5 years.
In calculating that amount, we make the assumption that Mrs. Smith would invest a sufficient amount in government bonds to eventually grow to cover the tax liability. We determine the present value of the contingent taxes on the RRSP by incorporating the amount of RRSP funds, the effective tax rate and the timing.
Chartered Business Valuators are often asked what the RRSP discount factor is. If we determine that Mrs. Smith will have a tax rate of 30 per cent in retirement and that 60 cents must be invested to grow to $1 when the RRSP tax will be paid 28.5 years in the future, the appropriate discount factor is 18 per cent (30 per cent x 0.6).
Based on the above, Mrs. Smith’s $1 million RRSP is equivalent to $820,000 in a bank account for matrimonial purposes. Understanding these contingent taxes is important to assess valuation issues during matrimonial litigation.
In summary, it is important to understand that separating spouses will get a deduction or a credit against the value of their RRSP to take into account the taxes on removal of the funds.