Tax Calculations For Separation and Divorce

June 2024

You need to understand a number of income tax concepts to negotiate fair settlements for separation and divorce.  In this article, I will discuss how income taxes affect net family property calculations and impact spousal support cash flow.  I will attempt to explain the difference between “average tax rates” and “marginal tax rates”, and when to use each.  I will discuss the calculation of tax rates.  I will close the article with a discussion about discounting for time value of money, including why the tax rate itself is not discounted, and an overview of how discount rates are determined for other matters.

Impact on Equalization of net family property (“NFP”) and support

Income taxes are a significant consideration involved in separation and divorce calculations in the two respects:

• For equalization of net family property calculations, income taxes are an important part of the valuation process. Your RRSP account balance of $100,000 is not really worth $100,000; you will need to pay taxes on that account to obtain your money.  If you have a tax rate of 40%, that RRSP is only worth $60,000, a significant difference.  Typical assets to consider include RRSPs, pensions, non-registered investment portfolios, business ownership, real estate holdings and employment assets (for example, accrued retiring allowances to be paid at retirement, unused vacation pay owing, bonuses declared but unpaid, deferred salary and profit sharing plans, untaxed restricted stock units and stock options, etc.).  Please see my article titled, “Taxes and Net Family Property Valuations of Pensions and RRSPS”
• For spousal support purposes, if you are paying or receiving regular periodic payments, then the payments are very likely to be deductible or taxable, respectively If the spousal support is $1,000 per month, and the payor’s tax rate is 40%, the cash required after the tax reduction will only be $600 per month.  If the recipient’s tax rate is 30%, they will be putting a net amount of $700 into their bank account.

Defining and differentiating  “average’ and “marginal” tax rates

Making this situation more complex is determining the appropriate income tax rate to apply.  Accountants who provide tax advice know the difference between a marginal tax rate (often referred to as the “MTR”) and an average tax rate, but other parties involved in the separation and divorce process may not be so fluent.

The average tax rate is simply the total taxes payable divided by the taxable income.  If your total taxes payable are $10,000 and your taxable income is $100,000, your average tax rate is 10%.

The marginal tax rate is the increase in taxes payable divided by a specific additional income amount that is added existing taxable income.   Assume you receive a work bonus of $10,000 in addition to your normal taxable income of the $100,000.  If your taxes increase by $4,000 from $10,000 to $14,000, then your marginal tax rate is $40%.  This is $4,000 extra tax divided by the additional income of $10,000.

In summary, your average tax rate started at 10% and  your bonus was subject to a marginal tax rate of 40%.  Assuming that such bonuses are not regular payments, it is reasonable to expect that your average rate will return to 10%.  However, for that one year only, your average will have increased from 10% to 12.7% ($14,000 divided by $110,000).

Calculating the tax rate is discussed further below.  The tax calculation must consider the person’s income in the year(s) in which it will be received.

When is use of the average tax rate appropriate?

In a separation and divorce scenario, the most important application of an average rate relates to valuation of RRSP and pension assets.  These assets will be taxed as they are received in the future during retirement.  The rationale for using the average rate is explained next.

If a person is receiving various types of retirement income on an annual basis, such as a lifetime work pension (Defined benefit pension (DBP)), Canada Pension Plan payments (CPP), Old Age Security payments (OAS) and withdrawals from a Registered Retirement Income Fund (RRIF), one cannot rationally deem that one type of income comes first.   Sometimes a person argues that the “marginal” tax rate should be used for an RRSP because it is being added on top of the other income, being the DBP, CPP, OAS.   We know that the RRSP must be withdrawn at some point in time, just as those other sources will be drawn at some time.  No one source of income has any particular priority over the other in retirement.  The same theory applies to salary, interest, dividends and other regular sources of income during your working years – no one item automatically comes sequentially before the others in retirement.

When is use of the marginal tax rate appropriate?

• Equalization of assets

A marginal tax rate should be used in relation to calculating taxes on a non-recurring receipt of taxable income.  This may be a capital gain upon the sale of an investment portfolio, a lump-sum work severance payment, a gain on disposal of real estate or even a lump-sum withdrawal from an RRSP for some type of priority payment requirement.  In such cases, the taxpayer already has their other regular income but these specific items are one time only payments added on top of their regular income.  In such cases, it is appropriate to deal with the tax on that item separately, which would result in using the marginal tax rate.  The taxpayer already has income tax on their normal income, with no reason to treat any of the existing sources differently, and with no expected future changes in their “normal” tax costs.  This additional bump in tax on the non-recurring income is a one-time extra cost and should be calculated using the marginal tax rate and deducted from the pre-tax value of the asset.

Assume you pay total taxes of $10,000 on pensions and regular income totalling $100,000.  Your average rate is 10%.  Assume you then sell a property with a fair market value of $100,000, and you have a taxable capital gain of $10,000 added to your income for one year only, and this results in an additional $4,000 of tax (a marginal tax rate of 40%).  Total taxes for that year are now $14,000.

If you apply the average rate of 10% to the gain of $10,000, you would only be accounting for total taxes for the whole year of $11,000 – 10% on the $10,000 and 10% on the 100,000.  What happened to the other $3,000 of taxes?  This extra tax cost is solely because of the one-time event, and should be applied to reduce the value of the asset to which it relates.

During a working career, one’s regular income is often salary.  At the date of separation, there may be assets owing to an employee for bonuses, restricted stock units, stock options, accrued vacation pay and retiring allowances, etc.  These will usually be drawn in the near future, and will be added to the top of regular salary.  I believe it is appropriate to reduce the value of these assets by the marginal tax rate.

Sometimes, depending on the size, the difference in dollar values may not be material, so one needs to be cautious not to incur excess professional fees doing a calculation that is insignificant.

• Spousal support

Another appropriate use of the marginal tax rate would be in relation to payment or receipt of spousal support.  Use of the marginal tax rate is appropriate to answer the questions:

• “How much additional cash flow after taxes will I receive from spousal support payments of $X?”
• “How much will it cost me after taxes to pay spousal support payments of $X?”

If the recipient of taxable spousal support has a marginal tax rate of 30%, and the gross support payment is $1,000 per month, they will retain $700 after taxes.  If the payer is in a 50% marginal tax bracket, it will cost them $500 after taxes.  There is a net benefit to the couple if the payer is in a higher tax bracket than the recipient.  (The tax effects may change if one party is a non-resident, or even if one party is a US (or dual) citizen living in Canada), .  Note that child support is neither taxable nor deductible in Canada.  Also, lump sum payments of spousal support are neither taxable nor deductible, unless the payment is made as a catch-up on arrears.  The taxability of support is subject to many tax rules, which is beyond the scope of this article and should be discussed with a tax advisor.

How are the appropriate tax rates determined?

The tax rate calculation must consider the amount of taxable income when the income or gains are taxed.

• Average tax rate determination

With respect to RRSP and pension income, this will likely be in retirement.  Estimating the average tax rate in retirement is difficult, and, at best, will be a reasonable estimate.  Income in retirement will vary depending on how the divorce process splits work pensions, CPP, RRSP and non-registered investment holdings, etc.  For example, if equalization of net family property results in the transfer of 50% of a spouse’s lifetime pension, it will decrease that spouse’s retirement income and increase income for the other individual.  On the other hand, if this same equalization is done by a transfer of money in a bank account without impacting future pension benefits, the results will differ.  And, of course, the final determination of asset splitting may differ from when you did your tax estimates.  Often, the changes will not have a material impact on the future taxes, although a swap of a bank account for a lifetime taxable pension could be significant if the values are large.

Future income will also depend on whether an individual is a regular saver with future contributions to an RRSP.  If so, they will have higher RRSP (or RRIF) withdrawals in the future.  Job changes, promotions, investment performance, disabilities and lots more future events can have impacts.  In order to determine the future average tax rate, we must use reasonable estimates based on what we know regarding the spouses’ history, intentions and capabilities, as well as the potential results from culmination of the separation negotiations.  In many cases, a modest difference in tax rates will not have a significant impact, particularly if the taxable assets being divided are small and the spouses have similar income and lifestyles.

The calculation process is, in summary, essentially as follows.  We estimate their income in retirement.  Their income will likely include, at least, CPP, OAS, withdrawals from their Registered Retirement Income Fund (RRIF) and investment income, plus any work pensions and other sources of income.  However, when calculating this income, you should use the amount in today’s dollar values.  Use today’s rates of OAS, CPP and pensions (increased for additional service years) without increasing them for inflation.  In that way, we can also use the current tax brackets without adjusting them for inflation.  With respect to RRSPs, we would include expected future contributions to calculate estimated RRIF withdrawals, but we would not project future investment returns on those savings.  By not adding future investment returns, we are maintaining the values in today’s dollars.

We use future estimated taxable income to calculate total taxes using today’s tax rates.  We determine the average tax rate by dividing total taxes by the total income.  There are online resources to help with this tax calculation, such as the EY Tax Calculator (https://www.ey.com/en_ca/tax/tax-calculators ) or Taxtips.ca Canadian Tax Calculator https://www.taxtips.ca/calculators/canadian-tax/canadian-tax-calculator.htm.  Once we have the tax rate, you then apply it to the asset values listed in the statement of net family property as appropriate.

While you may have another approach, the following table, with notes explaining the assumptions used in this example, sets out one approach to calculate the average tax rate.

• Marginal Tax Rate

For determining marginal tax rates, we need to estimate taxable income at the time that the relevant transaction will occur.  Estimate the taxable income before and after the non-recurring item.  Then, manually calculating the taxes at both income levels will give you the amount of additional taxes.  (Dividing this figure by the non-recuring amount gives you your rate, although the rate is not needed if you already know the tax amount).  Alternatively, instead of doing the manual calculation, you can look at federal and provincial tax rate tables (such as EY as noted above).  These tables should allow you to determine a reasonable marginal tax rate.  Using the example above, reference to the 2024 EY Personal Income Tax Rates table for Ontario will show that taxable income of $75,600 falls in the $55,868 to $90,595 bracket, which has a rate on excess of 29.65%.  This is the marginal tax rate on fully taxable income.  If a non-recurring item of $14,995 or less was received, you will see that it would be taxed at an incremental rate of 29.65% because the new taxable income would still be within the same bracket.  If a higher amount is received, the income would bear taxes at 29.65% for a portion, then 31.48% and so on, so you would need to do some additional math.

Should tax rates be discounted for the time value of money?

In a nutshell, “No.”  Because of the confusion over this concept, the following is a long explanation trying to satisfy accountants, like me, who have difficulty with the no answer.

The argument is sometimes made that these taxes on, say, the RRSP, are not due for many years in the future.  Therefore, a tax rate of 20% should be discounted for the time value of money, perhaps reducing it to 13%.  For example, paying 20% taxes on $100,000 in 20 years time is preferable to paying those taxes now, and so a rate of 13% would be used today.  However, the actuaries will tell you that there is a flaw in this theory when doing calculations for an equalization of net family property.  The fair market value of the RRSP in today’s dollars is $100,000 for taxes.  There is no question on that.  However, that RRSP will grow over the next 20 years – but that is future value.  The value today is, indeed, its present value.  We do not need to reduce the tax rate for the time value of money because of the RRSP has already been reduced.  To reduce tax rate would be to double count the present value calculation.

If you owe someone a fixed amount of cash, it is logically better to postpone paying it as long as possible.  In the meantime, you can earn some interest on money, which you can keep yourself.  However, if you need to give them the future interest you earn on your money, you will be no better off by waiting.  For example, assume I owe you $100,000 and you tell me that I can pay you now, or I can pay you that same amount in 20 years.  If I can invest money at an after-tax rate of 2% over the next 20 years, it will grow to $150,000.  At that time, I would pay you $100,000 and keep the balance.  This is obviously better for me.  If I need to pay you the full $150,000, then I may as well pay you the $100,000 now.  The “present value” of $150,000 using 2% is $100,000.  Looking at it another way, if I owe you $150,000 that is due 20 years from now, how much money would I need to offer you today to satisfy my debt with you?  If you knew that you could earn 2%, you would likely be willing to take $100,000 today.  In that way, you could invest the $100,000 and still have $150,000 in 20 years time.  Your benefit is that you would not need to worry about me defaulting on payment and you would already have the money should you need it for personal purposes sooner.

Now, let us apply those principles to the net family property value of an RRSP of $100,000 that is expected to be withdrawn in 20 years time, at which time it will be subject to a 20% tax rate.  It is clear that the present value of the RRSP before taxes is $100,000, and the tax liability would be $20,000 today at 20%.  Over 20 years, the RRSP will grow to $150,000.  The present value discount factor to bring the RRSP principal back to today’s dollars is 0.67.  ($150,000 x .67 = $100,000)

In the future, when the taxes are paid at 20%, the taxes will be $30,000.  Applying the same present value factor to the taxes brings the $30,000 back to $20,000.  The fact that the taxes are a percentage of the principal means that when we discount the future value of the RRSP, we are simultaneously discounting the dollar value of the taxes.  There is no impact on the tax rate!  We do not need to reduce the 20% tax rate because we are using the present value of the RRSP principal.

If you like looking at numbers, see below:

• Table 1 is showing the growth and application of the present value factor to the dollar values, ignoring the tax rate itself. This shows that the present value of the RRSP today is $80,000.
• Table 2 shows that using a discounted tax rate would result in a higher present value of the RRSP by $6,666, which is double counting the tax savings already included in Table 1.

Table 1 – RRSP After-tax Present Value

If discounting the future tax rate was relevant, you would do so by multiplying the 20% tax rate by the present value discount factor of 0.6667 as noted in Table 1.  See Table 2 as to how this would lead to double counting the discount, overstating the asset value by $6,666.  Keep in mind that a lower discount rate results in a higher asset value.

Table 2 – Comparison of Using Full vs. Discounted Tax Rate

What about discounting other amounts?

Ignoring income taxes for the moment, I discussed above how certain figures are discounted to obtain current values.  We are often asked the question, “What is the current value of future spousal support payments?”

It is often difficult for us non-actuaries to determine the correct discount rate to use.  In some cases, the rates or formula may be set out in law.  For example, this is an excerpt from the Prince Edward Island Rules of Court:

“CALCULATION OF AWARDS FOR FUTURE PECUNIARY DAMAGES

Discount Rate

53.09 (1) The discount rate to be used in determining the amount of an award in respect of future pecuniary damages, to the extent that it reflects the difference between estimated investment and price inflation rates, is 2.5 per cent per year.

Gross Up

(2) In calculating the amount to be included in the award to offset any liability for income tax on income from investment of the award, the court shall,

(a) assume that the entire award will be invested in fixed income securities; and

(b) determine the rate to be assumed for future inflation in accordance with the following formula:

g = (1 + i) – 1 (1+d)

where “g” is the rate to be assumed for future inflation;

“i” is the average yield on Government of Canada marketable bonds for durations of over ten years, as published in the edition of the Bank of Canada Weekly Financial Statistics appearing on or not more than six days before the date that the trial commenced, rounded to the nearest half of one per cent; and

“d” is the discount rate specified in subrule (1).”

The above legislation essentially states that the discount rate to use is the “real rate of return”, which excludes inflation, and then states that the real rate of return to be used is 2.5%.  An article by McKeating Actuarial Services, Inc., dating from 2015, discusses discount rates and the move by some provinces away from legislated use of mandated rates because of changes in inflation and investment returns.  That article is somewhat dated at this point, but is a good discussion on discount rates.

How does one determine the appropriate discount rate to use?  To discount an annuity that may or may not be indexed for inflation, such as spousal support, I asked an actuary for guidance, and this is the answer:

If it is a fixed annuity payable (i.e. $1,000 per month), non-indexed, you should use just the straight bond yield.

If is an indexed annuity, you have two choices,

• • project the annuity by inflation each year (i.e. $1,000 per month the first year, $1,020 per month for the second year, $1,040 per month for the third year, etc.) and then discount by the straight bond yield, or
  • apply a fixed annuity payable (i.e. $1,000 per month) and then discount with the real bond yield. This results in the same thing since the real rate is theoretically equal to (1 + bond yield) ÷ (1 + inflation rate), so when you discount by this factor it inverts, so (1 + inflation rate) ÷ (1 + bond yield), so you can see that it is the same thing to apply the (1 + inflation rate) to the annuity payment and the discount with the straight bond yield.

The formulae referred to above is established by the Canadian Institute of Actuaries Standard 4530.09.

Typically, the discount rate used for calculations such as this is the “risk-free interest rate”, for which Government of Canada Bond rates are considered appropriate.  There are two rates to consider.  There is the Government of Canada Benchmark Long-term Bond Yield. This is considered a “nominal” rate, which is the listed interest rate for fixed income securities such as bonds and guaranteed investment certificates, referred to above as the “straight bond yield”.  There is also the  Government of Canada Real Return Long-term Bond Yield.  This “real return” rate is the nominal rate minus the effects of inflation.  For example, if a bond is paying 5% when inflation is 2%, then the real return is 3%.

Where the annuity, such as spousal support, is indexed, the real return bond yield is the appropriate discount rate, as noted by the actuary explanation above.  That is because inflation is already accounted for by the annual increase in the payment.  If it is not indexed, then the Benchmark rate would be appropriate.  When it comes to complex discounting calculations, referral to an actuary is your best bet.

You can find the Benchmark and Real Return Long-term Bond Yields on the Bank of Canada web site for Canadian bond yields: 10-year lookup Bank of Canada web site.

Conclusion

In normal cases, average tax rates should be used for valuation of assets to be realized over many years, such as RRSPs during retirement.  Marginal tax rates are applicable for non-recurring transactions, such as a sale of assets or receipt of a lump sum bonus.  The calculation should consider the sum of all income in the year(s) when the assets are being taxed, but the income will be in today’s dollars and based on today’s tax brackets.  Calculation of the tax rate is, at best, an estimate, and professional advisors are not fortune tellers; however, the assumptions should be reasonable and defensible.  It is not necessary to discount the tax rate percentage because you are working with the present value of the assets to which the tax rate is tied, and hence the taxes have already been present valued on the same basis as the asset.

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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