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The Lowdown on Spousal IRAs

Let’s say you receive a lump sum during the year that lifts you into a higher income tax bracket and results in an unexpectedly large tax bill. Is there anything you can do?

What If a Lump Sum Doesn’t Qualify?

If you receive a lump sum payment that doesn’t qualify for special treatment, the payer will deduct certain federal, provincial and/or territorial taxes.

You may also have to pay additional tax on the amount when you file your return. To avoid that, you can ask the payer to:

1. Calculate the annual tax to deduct from your yearly remuneration, including the lump-sum payment;

2. Calculate the annual tax to deduct from your yearly remuneration, not including the lump-sum payment, and

3. Subtract the second amount from the first amount.

The result is the amount the payer will deduct from the lump-sum payment.

There are other methods involving deferred profit sharing plans, which your accountant can explain.

The payer will not deduct income tax from a lump-sum payment if your total earnings received during the calendar year, including the lump-sum payment, are less than the “claim amount” on the employee’s Personal Tax Credits Return. (This does not apply to non-residents.)

Generally, lump sum income is taxable in the year it’s received. But for certain lump sum payments, there is a special tax calculation that can help lower the taxes owed.

If the payment qualifies for “retroactive lump sum averaging,” it is treated as if it had been received in the year it applied to, even though the tax is paid in the year the lump sum is received.

Essentially, qualifying amounts relating to prior years are excluded from the current year’s taxable income and taxed at the rates applicable in the years when the money would have been paid. That can lower your overall tax bill.

Lump sum income that qualifies for the special treatment includes:

  • Spousal, common-law partner or child support payments.
  • Superannuation or pension amounts other than non-periodic benefits such as lump sum withdrawals.
  • Employment Insurance benefits.
  • Benefits from wage loss replacement plans, including long-term disability insurance if it is taxable.
  • Retroactive employment income.
  • Settlements and arbitration awards related to employment cases, such as a pay equity settlement.

To qualify for the calculation, the lump sum payment must total $3,000 or more and have been:

  • Paid for years when you resided in Canada for the full year.
  • Made after 1994 and apply to years 1978 and later.
  • Made in years not otherwise included in block averaging and years in which you did not file for bankruptcy.

The specified portion for a year is the amount of principal related to that year. Interest included in the lump sum payment is taxable in the year it is paid.

The lump sum average calculation is quite complex, and Canada Revenue Agency (CRA) performs it for taxpayers on request. In fact, the CRA may automatically make the calculation if it notices that the averaging is applicable to your return.

However, in order to do this, the CRA needs to know the qualifying amount for each year and the years to which payments apply. You should be able to find that information on the Statement of Qualifying Retroactive Lump-Sum Payment that you should receive from the payer. The statement shows:

  • The year the payment was made.
  • A complete description of the payment and the reason for it.
  • The total amount of the payment, broken down into principal and interest, if applicable.
  • The principal amount of the payment that applies to the current year and each preceding year.

Don’t Rush: Retroactive lump sum averaging may not make sense for you. Consult your accountant to help determine if you can benefit from this treatment.