Income splitting has hit the news recently and I’ve received a few emails from readers asking about it.
Here are the basics of income splitting and how it can be used to save money.
Income splitting is essentially when the transfer of income from one person (usually a higher income, and higher tax rate) to someone else (of a lower income, and lower tax rate).
The purpose of transferring the income from one person to another is to save on taxes. If one couple has a high income earner and a lower income earner, the person with the higher income will pay taxes at a higher marginal rate than the lower income earner.
In this case it would make sense to transfer income from the higher income earner to the lower one, since the marginal tax rate on the transferred income would be lower.
Ways of Splitting Income
There are a few ways to split income to save money on taxes:
- Paying your spouse or child to perform work for your business. If you have a corporation you are allowed to pay a salary to your common-law partner, spouse or child for any work that they perform. This makes sense when the income earned in the business is taxed at a higher rate than the spouse/child would pay personally, reducing the overall tax bill. There are certain restrictions on this rule, mainly that the amounts paid must be reasonable for the work performed and there must be actual work performed.
- Spousal RRSP contributions. Setting up a spousal RRSP makes sense if you expect your spouse to be in a lower income tax bracket than you when you retire. Withdrawals from the RRSP are taxed in the hands of the lower-income spouse which reduces the overall tax bill. As a bonus this strategy also reduces your exposure to the Old Age Security clawback.
- Investments made by the lower-income spouse. Assuming a couple has maximized both their RRSP and TFSA accounts, it may make sense to invest using a non-registered (fully taxable) account. In this case if one spouse has a higher income than the other (and therefore higher marginal tax rate), it would make sense to keep all investments in the name of the lower income spouse so that the investment income is taxed at a lower rate.
- Sharing Canada Pension Plan (CPP) income. CPP income can be shared between spouses to reduce the overall tax bill. Both partners must be at least 60 years old, one (or both) must be currently receiving CPP income and must have lived together when one (or both) made CPP contributions. This strategy should be carefully considered as it would affect the OAS clawback and spousal tax credit.
- Lending money to a spouse/child. In some cases it may make sense to lend money to a spouse/child for investment purposes. The marginal tax rate of the spouse/child would need to be lower for this strategy to make sense. For a full example click here.
- Pension income splitting. Eligible pension income can be split between spouses to lower the overall tax bill. Up to half of the eligible pension income can be split and a joint election must be filed. Even if both spouses are in the same tax bracket, splitting eligible pension income may still be worthwhile as it may increase the pension tax credit for the transferee (tax credit on the first $2,000 of eligible pension income).
New Income Splitting Measures for Families
Recently, the federal government announced new income-splitting measures for families. Up to $50,000 of income can be split between spouses, up to a maximum savings of $2,000.
The maximum savings of $2,000 means that most families with a combined income of approximately $75,000 or higher will not benefit as much as families that have a combined income between $60,000 and $75,000.
My guess is that the most recent announcement regarding income splitting is a gradual progression towards filing income tax returns as a family unit rather than individually.
In the United States couples can elect to file a joint return (or individually) – whichever will save them the most money.
Why Split Income?
The main reason people wish to split income is to save money on taxes. In most cases described above, the marginal tax rate is lowered which means the income is still taxed – but at a lower rate.
Disclaimer – there are many rules and stipulations that need to be considered with each situation. When considering whether any of the strategies above are right for you make sure you review your situation with a professional prior to implementing them.
Related: Hidden Advantages of the TFSA
Related: The Ways We Overpay on Taxes