What is income splitting?
Income splitting in Canada is a tax strategy that allows a higher-earning individual to transfer a portion of their income to a lower-income family member to reduce the overall tax burden. By shifting income to someone in a lower tax bracket, families can take advantage of the progressive tax system to decrease the amount of taxes they owe collectively. Common forms of income splitting include pension income splitting for retirees and spousal income splitting, which can involve contributing to a spousal RRSP. While it can lead to significant tax savings, the practice is subject to specific rules and limitations enforced by the Canada Revenue Agency (CRA) to prevent abuse.
Benefits of income splitting
Income splitting is highly beneficial for couples with significant income disparities and retirees seeking to optimize pension income. By redistributing income within a family, this strategy reduces tax liabilities through Canada’s progressive tax system, enhancing financial flexibility and enabling savings. It supports long-term wealth accumulation by allowing greater contributions to Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs), thus enhancing overall financial well-being and planning flexibility for Canadian families.
Below are some key benefits of income splitting, highlighting its potential to enhance financial well-being and planning flexibility for Canadian families.
- Tax savings: By transferring income from a higher-earning individual to a lower-earning family member, families can reduce their overall tax liability due to Canada’s progressive tax system, where income is taxed at graduated rates.
- Increased disposable income: Reducing the overall tax burden can result in more after-tax income available for spending, saving, or investing.
- Enhanced savings potential: Families can use the tax savings to contribute more to savings vehicles like Registered Retirement Savings Plans (RRSPs) or Tax-Free Savings Accounts (TFSAs), potentially enhancing their financial security.
- Flexibility in financial planning: Income splitting offers greater flexibility in managing family finances and planning for future goals, such as retirement or education funding.
- Optimized retirement planning: For retirees, pension income splitting allows couples to share eligible pension income, potentially reducing clawbacks on Old Age Security (OAS) and other government benefits.
- Benefit optimization: By managing household income more effectively, families can optimize their eligibility for certain means-tested government benefits or credits.
It’s important for individuals considering income splitting to consult with a tax professional to ensure they adhere to Canadian tax laws and fully understand the implications of their financial strategies.
Types of income splitting and eligibility criteria
In Canada, income splitting can be achieved through several methods, each designed to leverage tax savings within the framework of existing laws. Here are the main types of income splitting:
Spousal income splitting
Contributions can be made to a spousal Registered Retirement Savings Plan (RRSP). The contributing spouse can claim the deduction while the receiving spouse is taxed on withdrawals at hopefully a lower rate during retirement.
Eligibility:
- The contributing spouse must have available RRSP room and contribute to a spousal RRSP.
- The receiving spouse can withdraw the funds and will be taxed on the withdrawal at their rate, provided certain conditions are met (e.g., the funds must remain in the RRSP for a specified amount of time to avoid attribution rules).
Pension income splitting
Retired couples can split up to 50% of eligible pension income. This can reduce the couple’s overall tax burden by shifting income to a spouse in a lower tax bracket.
Eligibility:
- Couples must be married or in a common-law partnership.
- At least one spouse or partner must receive eligible pension income, which typically includes life annuity payments from a pension plan and, for individuals aged 65 or older, includes RRSP annuities, RRIFs, and LIFs.
- Up to 50% of the eligible pension income can be allocated to the other spouse for tax purposes.
Business income splitting
In family-run businesses, income splitting can occur by paying salaries to family members in lower tax brackets for work they perform. It is essential that the work is legitimate and the compensation reasonable.
Eligibility:
- The family member must perform legitimate work for the business and be reasonably compensated for it.
- Compliance with “Tax on Split Income” (TOSI) rules, which apply to income received from private corporations and are designed to prevent income splitting with family members who are not actively engaged in the business.
Investment income splitting
Income from investments can be attributed to a child or lower-income family member, though attribution rules often apply to prevent misuse. Using registered accounts in a minor child’s name, like an in-trust account, is a common approach.
Eligibility:
- Investments in a child’s name must follow attribution rules unless structured properly to avoid them, such as through a formal trust arrangement.
Family trusts
Income generated from a family trust can be distributed to beneficiaries, who may be in lower tax brackets, thus reducing the family’s overall tax burden.
Eligibility:
- Beneficiaries must be correctly identified, and income distributions should be compliant with both trust law and tax rules.
Canada child benefit (CCB) optimization
While not traditional splitting, structuring family income can affect eligibility for means-tested benefits like the CCB, indirectly resulting in tax savings.
Eligibility:
- Household income must be structured to optimize eligibility for the Canada Child Benefit, as it is a means-tested benefit.
- Ensuring that family income is reported accurately and tax planning strategies do not unintentionally elevate household income above thresholds that would reduce the CCB.
How to set up income splitting in Canada
Each year, couples wishing to split pension income must jointly elect to do so by completing and submitting Form T1032: Joint Election to Split Pension Income. This form requires signatures from both spouses and must be filed with their tax returns for the applicable year. It’s important to note that a new Form T1032 must be completed annually for each year the election is made.
Income splitting use cases
Case Study 1: Pension Income Splitting for Retirees
A retired couple realized significant tax savings by splitting pension income. By transferring 50% of the higher-earning spouse’s pension income to the lower-earning spouse, they reduced their overall tax liability by taking advantage of both lower tax brackets.
Case Study 2: Business Income Splitting in a Family Business
A small family business owner paid salaries to their adult children, who were actively involved in the business, at a reasonable market rate. This not only resulted in tax savings by reducing the owner’s income taxed at a higher rate but also helped fund the children’s education savings plans.
Case Study 3: Investment Income Splitting through a Family Trust
A family set up a trust to manage investment income, distributing the income to children who were in a lower tax bracket. This strategy effectively minimized the family’s total tax liability while optimizing funds available for future investment.
Limitations and Considerations
While income splitting offers potential tax savings, there are several potential drawbacks and risks associated with implementing such strategies in Canada:
- Complexity and Compliance Risk: Navigating the rules and regulations for income splitting can be complex, particularly with the application of rules such as the Tax on Split Income (TOSI) and attribution rules. Misinterpretation or non-compliance can result in penalties or reassessments by the Canada Revenue Agency (CRA).
- Impact on Government Benefits: Restructuring income through splitting may inadvertently affect eligibility or the amount received from means-tested government programs, such as the Canada Child Benefit (CCB) or Old Age Security (OAS).
- Legal and Family Implications: Arrangements involving trusts or shared ownership can lead to legal disputes or family disagreements if not properly managed and communicated.
- Audit Risk: Complex income splitting tactics may increase the likelihood of attracting a tax audit. The CRA may scrutinize transactions to ensure they comply with all relevant tax laws and genuinely reflect commercial reality.
- Changes in Legislation: Tax laws and regulations are subject to change. Strategies that are effective under current rules may become obsolete or problematic if laws change, necessitating continuous monitoring and adjustment.
Differences between income splitting and income sharing
In Canada, income splitting is a tax strategy that distributes income from higher earners to lower earners within a family to reduce overall tax liability, using methods like spousal RRSPs and pension splitting. It is subject to tax laws such as the Tax on Split Income (TOSI) rules. Conversely, income sharing involves distributing income within a household or community based on mutual agreements, focusing more on equitable resource distribution rather than tax savings, and is governed by different regulatory considerations.