Income splitting is a powerful tool that has been around for some time and can have favourable impacts on tax savings. With the highest marginal tax rates being more than half of the income, income splitting strategies are now more beneficial than ever.
These strategies reduce overall income taxes due, allowing individuals to pay taxes at different tax brackets and potentially taking advantage of lower income tax brackets. All of these options should be explored and carefully considered to ensure the best outcome.
What is Income Splitting?
Income splitting is a popular tax reduction strategy used by Canadian families to reduce their overall income taxes. It involves transferring income from one family member with a higher income to another family member with a lower income to take advantage of the lower tax brackets available for individuals earning less money. Income splitting can be an effective way for couples or other family members to minimize their overall tax burden and maximize their after-tax income. However, certain rules and regulations govern how much income can be split between taxpayers, making it important for those looking into these strategies to understand the specifics before taking any action.
7 Strategies for Income Splitting
Let’s look at seven effective strategies below for income splitting in Canada that can help families save money on taxes. From using spousal RRSPs to taking advantage of split pension income, these strategies provide opportunities for Canadians to take full advantage of the Income Tax Act provisions while reducing their overall tax bill.
Pension Income Splitting
Pension splitting is an income splitting strategy available to Canadian taxpayers during retirement. By electing to split eligible pension income of up to 50% with a spouse or common-law partner, couples can reduce the total tax liability on their income and take advantage of certain credits and benefits that are based on net income. Any income you receive from your pension eligible for the $2,000 Canadian Federal pension income tax credit can be split.
The split income opportunity is available for eligible income from a Registered Pension Plan (RPP) irrespective of age and includes Registered Retirement Income Fund (RRIF) withdrawals upon reaching age 65.
If you are over 65, one of the best income-splitting strategies is to convert a portion of your individual retirement account, Registered Retirement Savings Plan (RRSP), into an RRIF because any withdrawals from your RRIF can be considered for pension splitting.
Income splitting of pension income in Canada is made possible through the T1032 election. This election allows you and your spouse or partner to make a joint election on your tax returns, allowing up to 50% of your pension income to be split between the two parties. The election must be made annually and is optional, so each year, you can decide whether or not to split your pension. Making this election can help reduce overall taxes paid by both parties involved in the income-splitting work.
Income from the Canada Pension Plan (CPP) and Quebec Pension Plan (QPP) cannot be split in the same way, although there are other avenues to share your CPP retirement pension or Quebec retirement pension with your spouse or partner. It can be accomplished by filing the Application for CPP Pension Sharing of Retirement Pension(s) – ISP1002.
To get the most out of splitting pension, couples should take into account both their net income amounts before and after income splitting. It’s important to carefully consider both spouses’ marginal tax bracket for the year to make an informed decision about whether splitting pension will reduce their tax burden.
In addition, it has the potential to provide significant tax planning opportunities and benefit from certain credits and benefits that are based on net income. By allocating a portion of your pension to your spouse or partner, you may be able to preserve certain income-tested tax credits and benefits, such as Old Age Security (OAS), GST/HST credit, and Canada Child Tax Benefit.
Spousal or Common-Law Partner RRSP
If you and your spouse or partner have different income levels, income splitting via spousal RRSP can be a great way to reduce your tax burden. Contributing to a spousal RRSP account is one of the most popular income splitting strategies in Canada since it allows you to split up to 100% of your RRSP income with your lower-income spouse or partner. This strategy offers greater potential tax savings compared to pension splitting since it is only limited to a 50% split.
A spousal RRSP is a Registered Retirement Savings Plan (RRSP) to which you make the contributions, but to which your spouse or partner is the annuitant (owner) of the plan. When your spouse or partner withdraws funds from a spousal RRSP at a later tax year, those funds are taxed in their hands rather than yours. It can result in overall tax savings if one person has income that’s taxed at a higher tax bracket than the other. This is because when the money is withdrawn from the plan by the spouse in a lower income tax bracket, they pay tax at a lower amount than if the higher income spouse had withdrawn it.
It is important to note that withdrawing from a spousal or partner RRSP within three years of contributing can have adverse tax consequences. In this case, attribution will occur, meaning you must include in your own income the amount of the withdrawal from the spouse’s RRSP in the current year, or the amount of your contributions to spousal or partner RRSPs in the past three years, whichever is less.
Also, one of the key benefits of spousal RRSPs for income splitting is that it allows couples to income split before age 65. Other than Registered Pension Plan (RPP), splitting pension is generally not available under age 65. Spousal RRSP can help income split without having to wait until retirement age.
Spousal or Common-Law Partner Loan
One of the most effective ways to split income is through spousal or partner loan arrangements. A spousal or partner loan is a loan made from one family member to another at the prescribed interest rate determined by the Canada Revenue Agency (CRA) on a quarterly basis. The lender spouse/partner lends money to their lower income spouse/partner and charges interest, which is tax-deductible for the borrower and taxable income for the lender with a potential tax reduction advantage.
The prescribed interest rate used to be 1%, representing a historically low rate that remained until June 30, 2022. It made spousal or partner loan an attractive option as both income splitting and income growth can be achieved. The loan can be used to transfer income-earning assets from one spouse or partner to another, while allowing the receiving spouse or partner to benefit from lower tax bracket on income generated by those assets.
To illustrate, let’s say James, who is in the highest tax bracket and Sophia, who is in the lowest tax bracket, enter into an income-splitting agreement where James loans Sophia $700,000 at a 1% interest rate secured by a promissory note. Sophia invests that money and earns ordinary income at 5%, so she reports $35,000 on her tax return. On an annual basis, she takes $7,000 of that income to pay interest of 1% on the principal of the loan and deducts interest expense of $7,000. James then reports interest income of $7,000 received from Sophia on his tax return. By doing this, instead of having $35,000 reported by James at the highest rate, it has been reported by Sophia at the lowest rate, resulting in significant tax savings.
However, the prescribed interest rate is currently at 3% due to the current market conditions. It may still be a good tax reduction strategy depending on the anticipated return on your investment. If you take part in a spousal loan agreement when the prescribed interest rate is 3% or a higher rate, and that rate drops again in the future, you should consider selling investments made with funds from the original 3% loan and pay back the loan to your spouse or partner. Subsequently, you can take a part in a new loan agreement using the new, lower prescribed interest rate. However, note that paying back a loan at a higher prescribed rate with a loan at a lower prescribed rate may violate the attribution rules if handled incorrectly.
To ensure you’re fully compliant with the CRA, all loans must be documented in writing, and interest must be paid annually by January 30 of the following year. The Income Tax Act includes an attribution rule that generally attributes income or capital gains earned on money gifted or transferred to a family member back to the original transferor. However, if money is loaned at the prescribed interest rate in effect when the loan was originated and interest is paid each year within 30 days after the end of the calendar year, then this attribution rule does not apply.
Prescribed Rate Loan to a Family Trust
We have already covered the benefits of spousal loans, but similar benefits can be achieved when making a loan to a family trust instead of a spouse or partner.
Making a loan to a family trust can be an effective income splitting strategy for parents who want to help fund the costs of private school, sports, music lessons, and other extracurricular activities for their children. With this strategy, the income or dividends earned on the loaned funds are attributed back to the parent and taxed in their hands at their marginal tax bracket. However, if the parent charges interest on the loan at the prescribed rate and pays it within 30 days of calendar year-end, any income earned above that rate can be taxed in the child’s hands. This income can be received entirely tax-free if they have minimal or no income.
The solution is to lend funds to a family trust with minor children as beneficiaries, where payments can be made directly to them or used for their benefit. The trustee then invests the funds and pays out any net investment income after the loan interest is taken into account. For children in post-secondary schools, this income may be able to be received tax-free due to various credits they may claim. Ultimately, making a loan to a family trust is an effective way to split income between parents and their minor children while minimizing taxes.
Loan to an Adult Child (to Buy a Home)
Many parents are in the position of having to decide whether to gift or lend money to their adult children, especially when it comes to helping them buy their first home. Gifting funds to an adult child who is 18 years or older is an option, but if you would like the extra security of a secured loan where repayment may be expected, income splitting needs to be taken into consideration.
In most instances, when you gift or loan money to your adult child to purchase a home, there will generally be no income generated and therefore, no income attributed back to mom or dad that would be taxable income. Additionally, if your adult child claims the principal residence exemption on the sale of their house, there will also be no attribution of capital gains income back to you. So, in this case, there’s no need (or requirement) to charge interest on the loan.
But what happens if your adult child plans to earn income from the house, such as by renting it out? In situations where income may be generated from the property, interest must be charged at the prescribed rate (or higher) so that income generated by rental payments – or any other type of income – won’t be attributed back up to you and become taxable income for you. It’s important also to note that even though charging interest provides protection from tax attribution from your adult child’s investment property; you would still have to pay taxes on any interest income earned from lending funds in this manner.
Also, remember that renting out part or all of a home can sometimes prevent your adult child from claiming the principal residence exemption, meaning that their capital gain upon eventual sale could become attributable back up to you as taxable income. As such, parents should consider providing financial assistance using a prescribed rate loan rather than gift funds when helping their adult children purchase their first home.
Pay Salary to a Family Member
Hiring your family member to work for you as an employee can be a great way to income splitting, but you need to take proper precautions and follow the rules so that you don’t find yourself with an invalid tax deduction. It is vital to ensure the amount paid is reasonable based on the duties performed and to keep good records of timecards and payments.
The salaries are deducted from the sole proprietor’s personal or corporate tax returns, depending on the business structure. Additionally, it is necessary to make payroll deductions for Canada Pension Plan (CPP) contributions, Employment Insurance (EI) premiums, and income taxes. Lastly, T4 slips must be issued to report salaries and deductions, which will be included in personal tax returns. Taking these steps can help provide financial benefits while avoiding potential penalties for not following the tax rules and regulations set forth by the Canada Revenue Agency.
Paying a Family Member as a Shareholder
Paying a family member as a shareholder is often a strategy for income splitting purposes. Income splitting through private corporations can be subject to Tax on Split Income (known as “TOSI”), and the rules have been introduced in recent years. TOSI applies to income that is received, either directly or through a family trust, by someone under the age of 18 from a related private corporation. TOSI also applies to adults if a related adult (e.g. spouse or partner) is actively engaged in the corporation’s business or holds a significant amount of equity (with at least 10% of the value) in the corporation.
For income received by minors, income is taxed at their parent’s highest marginal rate and cannot be sheltered by basic personal tax credits. For income received by adults, TOSI may limit splitting income strategies with family members who are shareholders. The rules contain a number of exceptions; however, they are complex and tax professionals should be consulted to ensure compliance with them. One such exception exists when income splitting between shareholders and their spouses or partners occurs in retirement – provided the shareholder involved in the business is at least 65 years old. This rule is consistent with applicable pension splitting rules for Registered Retirement Income Funds (RRIF) after 65 years of age.
Income splitting can still be achieved through private corporations, but it’s important to understand all applicable TOSI rules before proceeding with this strategy so that any taxes due are correctly calculated according to these regulations.
When you and your family member are not in the same tax bracket, income splitting strategies can be highly beneficial. Splitting pension income is an effective technique that retirees can use to reduce the couple’s overall tax liability. Converting some RRSPs to RRIFs is another strategy that may help retirees, and spousal RRSPs are also viable options for income splitting in retirement.
Those who expect to accumulate significant non-registered investments could look into making a prescribed rate loan to a family member, possibly with a family trust structure. This way, the higher-income spouse or common-law partners can split income without paying unnecessary taxes.
Business owners may also benefit from income splitting by employing a family member or including them as shareholders of their corporation. This could lead to thousands of dollars in annual tax savings. With careful planning and proper tax advice, these strategies can be utilized as a powerful tool for reducing the tax bill and optimizing wealth distribution among family members. Contact us if you have any questions about income splitting.