Are you tired of paying hefty taxes in Canada? I know I am! It’s frustrating to see a significant portion of our hard-earned money disappear into the hands of the taxman.
If you’re like me and want to find ways to reduce your overall family’s tax burden, income splitting is the perfect solution. It’s a proven strategy that allows you to shift some of your higher income to your spouse or common-law partner, who earns a lower income.
In this article, I will discuss all you need to know about income splitting in Canada. I will share five strategic ways to use income splitting in Canada effectively to lower your overall tax bill and relieve your wallet.
What is Income Splitting?
Income splitting in Canada allows couples to redistribute income between spouses to lower their overall tax burden. By shifting income from a higher-earning spouse to a lower-earning spouse, families can take advantage of reduced tax rates and retain more of their hard-earned money.
While income splitting is commonly associated with retirement, planning for it as early as possible is beneficial. One effective approach is diversifying your savings between spouses, ensuring they are not concentrated in a single account or investment.
Consider the scenario of George and Shelly, a couple in their late 30s. George earns $300,000 annually, while Shelly earns $70,000. Instead of exclusively contributing to his own RRSP (Registered Retirement Savings Plan), George can allocate some of his savings to a spousal RRSP.
This strategy aims to equalise both spouses’ RRSPs by the time they retire. By drawing income from two smaller RRSPs rather than one large one, George and Shelly can significantly reduce their tax burden.
5 Income Splitting Strategies to Reduce Your Tax Burden in 2024
Here, we will explore five effective income-splitting strategies that can help you reduce your tax burden. By implementing these strategies, you can optimise your tax liabilities and keep more of your hard-earned money.
Strategy 1: Split Your Pension Income with your Spouse
Pension income splitting is a powerful tool for spouses or common-law partners who receive eligible pension income. It allows you to lower your overall taxes by transferring income from a higher-income spouse to a spouse in a lower tax bracket.
If you and your partner are 65 or older, you can split up to 50% of your qualified pension income.
Let’s paint a picture with an example: Imagine you, as the higher-income spouse, have approximately $120,000 in eligible pension income, while your spouse earns around $32,000 in retirement income. Shifting about $42,000 of your pension income to your spouse can significantly reduce your family’s tax burden.
You and your spouse must make a joint election on your income tax returns to make this happen. Completing the Joint Election to Split Pension Income form is essential when filing your taxes.
However, you should know that not all income can be split. The following are eligible incomes that can be split:
- Lifetime annuity payments from an RPP, RRSP, DPSP, and Retirement Compensation Arrangement (RCA)
- Payments from an RRIF, LIF, LRIF, PRIF
- Taxable foreign pensions
- Interest from a Guaranteed Interest Annuity (GIA)
- Interest in a non-Registered Life Annuity
The following are incomes that cannot be split:
- Canada Pension Plan (CPP), Quebec Pension Plan (QPP)
- Old age security (OAS), Guaranteed income supplement (GIS)
- Any foreign source pension income that is tax-free in Canada because of a tax treaty that entitles you to claim a deduction
- Income from a US IRA
Aside from the tax-saving benefits, splitting pension income can also impact credits and benefits that are solely based on one spouse’s or partner’s net income.
Advantages of Pension Income Splitting:
- Reduced Taxable Income: Income splitting becomes advantageous when you and your spouse are in different tax brackets during retirement. You can lower your family’s overall tax bill by splitting your income. This is particularly beneficial if you have additional income sources like investments, rental properties, and government pension benefits.
- Easy Setup: Setting up income splitting is a breeze. When filing your personal tax returns, simply fill out the Joint Election to Split Pension Income form. It’s a straightforward process that can yield significant tax savings.
- Pension Income Tax Credit: The federal government and most provinces (excluding Quebec) offer additional tax credits for pension income. If you split your pension income with a spouse not receiving a pension, they can claim up to 15% of $2,000 in eligible pension income as a Pension Income Tax Credit. This credit can result in a maximum federal tax savings of $300.
Drawbacks of Pension Income Splitting:
- Same Tax Bracket: Income splitting does not provide any benefits if you and your spouse are in the same tax bracket. In this case, there would be no advantage to splitting your pension income.
- Restrictions: Not all pension income is eligible for splitting. For instance, Old Age Security payments cannot be split. It’s important to be aware of these restrictions and understand which types of income can and cannot be split.
Strategy 2: Lend Money to Your Spouse
If you earn significantly more than your spouse, you can loan money to your spouse at the Canada Revenue Agency’s (CRA) prescribed rate, which is currently set at 1%. By loaning money to your spouse, they can invest the funds to earn a higher return than the prescribed rate while saving tax for the entire family.
Since your spouse is in a lower tax bracket than you, any dividends earned from their investments will be taxed at their lower tax rate. This means you can effectively shift income from your higher tax bracket to your spouse’s lower tax bracket, reducing your overall taxable income.
But the real magic happens when your investments generate returns that exceed the prescribed rate set by the CRA. This strategy becomes even more advantageous as you reduce your taxable income and benefit from higher investment returns.
Using the spousal loan strategy, you can take advantage of the income splitting opportunity, lower your tax burden, and potentially increase your investment gains. It’s a win-win situation that can significantly impact your financial well-being.
Advantages of Spousal Loans:
- Stable loan terms: When utilising a spousal loan, the loan is set at the prescribed rate determined by the Canada Revenue Agency (CRA) at the time of issuance. This means there are no uncertainties or fears of rate increases, and interest must be paid by January 30 each year, providing clarity and predictability in the repayment schedule.
- Win-win for income shifting: The high-earning spouse declares the interest paid to them as income, but their overall income only increases by the prescribed rate (currently 4%). Similarly, the lower-earning spouse must declare any dividends or income from the loan. The family still benefits if the lower-earning spouse receives a rate of return higher than the prescribed rate (e.g., greater than 4%). Moreover, the income earned is taxed at the lower-income earner’s rate, further enhancing the tax advantages.
- Deductibles: Any interest payments made can be deducted from the lower-income earner’s taxable income, helping to reduce their overall tax liability.
Drawbacks of Spousal Loans:
- Legal requirements: Establishing a spousal loan necessitates the creation of a loan agreement or promissory note to formalise the arrangement and define the terms. Seeking legal counsel is highly recommended to ensure compliance and avoid legal complications.
- Estate complications: If either spouse passes away before the loan is repaid, it can introduce complexities for the executor and next of kin, particularly if estate plans do not account for these scenarios. Including provisions in estate plans to address spousal loans and ensure a smooth transition is crucial.
- Accounting complications: Implementing this income-splitting strategy involves additional tax reporting obligations, which may require professional accounting support. This adds to the overall cost, especially for individuals who typically handle their own tax returns.
- Record keeping: Detailed records of transactions must be maintained in case of a CRA audit. While not overly burdensome, it does add to the administrative responsibilities, particularly for small business owners who already have other paperwork to manage.
- Costs: Establishing a spousal loan correctly incurs various costs, such as legal advice, estate planning, and potentially additional accounting support. These expenses must be carefully weighed against the potential rate of return to ensure that the financial benefits outweigh the associated costs.
Strategy 3: Make Contributions to a Spousal RRSP
If you earn a higher income than your spouse, then they will likely have less income during retirement. So, how can you leverage income splitting to your advantage? Enter the spousal Registered Retirement Saving Plan (RRSP) strategy.
Here’s how it works: you can utilise your RRSP contribution room to boost your lower-earning spouse’s RRSP and claim the associated tax deduction. While this approach reduces the amount you can contribute to your own RRSP, it offers significant tax benefits for both of you.
When your spouse withdraws money from their RRSP during retirement, they will be taxed at their lower income level. This reduces taxes paid overall, lightening the burden on your family’s finances.
Essentially, the spousal RRSP strategy allows you to redistribute income, ensuring you and your spouse benefit from optimal tax advantages. By taking advantage of this income splitting strategy, you can minimise your family’s tax burden and set yourselves up for a more secure financial future.
Advantages of Making Contributions to Your Spousal RRSP:
- Simple Setup: Unlike a spousal loan, setting up a spousal RRSP is quick and doesn’t require extensive tax, accounting, and estate planning assistance.
- Immediate Tax Advantage: The higher-income earner can enjoy immediate tax benefits through a tax-deductible contribution to the spousal RRSP.
- Long-Term Stability: During retirement, the lower-income earner benefits from income stability while leveraging the lower tax rate when converting the RRSP to an RRIF. This strategy effectively reduces the overall tax burden on the family without significant effort.
Drawbacks of Making Contributions to Your Spousal RRSP:
- Limited Early Withdrawals: To avoid triggering tax implications, funds must remain in the spousal RRSP for a minimum of three years from the last contribution. If withdrawals occur within this period, the contributor may face taxation as per CRA attribution rules. The recipient’s taxable income will include withdrawals made after three years.
- Contribution Limitations: This strategy relies on the higher-earning spouse having an available contribution room. They cannot contribute to the spousal RRSP if they have reached the maximum contributions for a given tax year, even if the lower-income spouse has contribution room.
Strategy 4: Max Out Your TFSAs
Tax-free savings accounts (TFSA) are a powerful tool for income splitting that can greatly benefit your tax planning. With a TFSA, you don’t get tax deductions when contributing, your investments grow completely tax-free which means the account’s earnings and capital gains are shielded from taxes.
You also get to withdraw funds from your TFSA tax-free. And here’s where income splitting comes into play: if you earn more than your spouse, you can provide them with cash to contribute to their TFSA. This way, you can directly contribute to your spouse’s TFSA and take full advantage of the income splitting strategy.
The flexibility of a TFSA is what makes it stand out compared to other savings options like an RRSP. Unlike an RRSP, you can withdraw money from your TFSA anytime without incurring penalties or tax consequences. Plus, the power of compound interest means your money grows exponentially over time, significantly impacting your family’s overall wealth.
By leveraging the benefits of TFSA income splitting, you can optimise your tax savings while building a substantial nest egg for your future. It’s a win-win situation that allows you to maximise your financial resources and secure a brighter financial future for you and your loved ones.
Advantages of Maxing out your TFSA:
- Tax-free growth: Your Tax-Free Savings Account (TFSA) earnings grow without being subject to taxes. This means that any future profits or gains made within your TFSA remain entirely tax-free.
- Flexibility in withdrawals: Unlike spousal Registered Retirement Savings Plans (RRSPs) with a mandatory three-year waiting period for withdrawals, TFSAs allow you to access your funds whenever needed. You can withdraw money from your TFSA without any restrictions or penalties.
- Maximising spousal contributions: When it comes to contributing to your spouse’s TFSA, you can maximise their contributions without worrying about attribution rules, as you would with spousal loans. This allows you to maximise your combined TFSA contribution room and optimise your tax-free savings.
Drawbacks of Maxing out your TFSA:
- Easy access to funds: The ease of withdrawing money from a TFSA can be a double-edged sword. While it offers convenience, it also presents the temptation to withdraw funds prematurely, potentially hindering the long-term growth potential of your savings.
- No immediate tax break: Unlike contributions made to an RRSP, contributions to a TFSA are not tax-deductible. This means that TFSA contributions do not directly reduce your taxable income. While you won’t receive an immediate tax benefit, the advantage lies in tax-free growth and tax-free withdrawals in the future.
Strategy 5: Pay Dividends to Your Spouse and Children
One powerful income splitting strategy is to set up an incorporated business and include your spouse and children as stakeholders. This approach provides you with tremendous flexibility, as you can choose to distribute dividends to different family members based on your tax optimisation goals each year.
Imagine this: You have your own business, and you’re looking for ways to reduce your tax burden. Involving your spouse and children as stakeholders in your incorporated business opens up a world of possibilities.
Instead of taking all the profits as personal income and being subject to higher tax rates, you can allocate a portion of the earnings as dividends to your family members. This effectively spreads the income among your loved ones, allowing you to take advantage of their lower tax brackets.
Suppose you earn $100,000 in annual profits from your business. Instead of shouldering the full tax burden on that amount, you can pay out $30,000 in dividends to your spouse and $20,000 to your children.
By doing so, you’re effectively reducing the taxable income in your hands while shifting it to family members who may be in lower tax brackets. This strategy lowers your overall tax liability and helps build financial security for your spouse and children.
However, consulting with a tax professional is important to ensure compliance with relevant laws and regulations.
Advantages of Income Splitting
Pension income splitting is a powerful tool for couples in different income levels and tax brackets. Let’s take a closer look at how it works and who can benefit from it.
Income splitting can be incredibly advantageous if you are a high-income earner in a higher tax bracket. Even in retirement, you may still have substantial income from investment accounts. By splitting that income with your spouse or common-law partner, you can reduce your tax obligation to a minimum.
However, it’s important to note that income splitting may not be necessary if you and your spouse or common-law partner are in the same tax bracket during retirement. Your tax burden may already be balanced, and additional income splitting might not provide significant benefits.
To illustrate this, let’s consider an example. Imagine you’re a high-income earner in a higher tax bracket, while your spouse or common-law partner has a lower income and falls into a lower tax bracket. By splitting your pension income, you can shift a portion of it to your partner, effectively reducing the overall tax paid by your household.
Final Thoughts on Income Splitting Canada
Income splitting in Canada is a game-changing strategy for reducing your tax burden and maximising your financial well-being. By strategically shifting income between spouses, you can take advantage of lower tax rates and keep more of your hard-earned money in your pocket.
So don’t let the complexities of the tax system hold you back. Explore the various income-splitting strategies we’ve discussed and find the ones that align with your financial goals and circumstances. Consult with a knowledgeable financial advisor to ensure you’re making the most of this tax-saving opportunity.
Take control of your financial future and start implementing income splitting strategies today. Whether you’re planning for retirement or enjoying your golden years, income splitting can make a real difference in your overall tax pay and provide greater financial security.
FAQs on Income Splitting Canada
Who is eligible for income splitting in Canada?
To be eligible for income splitting in Canada, you and your spouse or common-law partner must live together in Canada during the appropriate tax year. Although there might be an exception in certain cases involving medical, educational, or business issues.
What income can be split between spouses?
Lifetime annuity payments from an RPP, RRSP, DPSP, and Retirement Compensation Arrangement (RCA), Payments from an RRIF, LIF, LRIF, PRIF, and Taxable foreign pensions. Interest from a Guaranteed Interest Annuity (GIA) and Interest from a non-Registered Life Annuity.
Is pension splitting a good thing?
Yes. Pension splitting is good when one spouse makes a lot more than the other. This can decrease the household’s tax burden, allowing the couple to pay less.
Is income splitting allowed in Canada?
Yes, Canada allows income splitting. Pension income splitting will enable retirees to contribute up to 50% of their qualified pension income to their spouse or common-law partner. However, to split pension income, you must meet specific criteria.
What are income splitting rules in Canada?
Canada’s income splitting rule requires that the couple looking to split their income live together in Canada within the tax year for which they are splitting income.
What is the benefit of splitting pension income?
Splitting pension income brings your family’s income into a lower total tax bracket; therefore, you can pay less in taxes.
How does income splitting work in Canada?
For income splitting to work, both spouses must elect to split income when filing their taxes every year. The couple must fill out form T1032 to elect to split their income.
