Income splitting is a tax strategy available to couples in Canada. Will this work for you? Read our article to find out
Taxes are a part of life. The basic services that Canada provides – building roads and bridges, providing social services, and funding government projects – all come from taxes. But let’s face it, taxes can put a financial strain on families, regardless of how much they earn.
Fortunately, the concept of income splitting is there to help ease the strain. It’s a strategy that more married couples and common-law partners are using to help them meet their tax obligations.
In this article, we’ll explore the idea behind income splitting in Canada. We’ll also go over basic definitions, who qualifies and who doesn’t, and techniques to maximize income splitting. We hope to share some insight into how income splitting in Canada can work for you.
Income splitting in Canada is a tax strategy that allows Canadian taxpayers to distribute a part of their income among the family members. This also helps take advantage of low tax rates and reduce the overall tax burden.
Even though income splitting provides many benefits, it is not a one-size-fits-all solution. It’s important to understand the details of this strategy to see how it works best for you and your household.
Aside from income splitting, you may often come across the term “CRA split income.” This refers to the aspect of taxation that only pertains to income allocation. In 2018, the federal government released new rules about income splitting within private corporations.
Under the previous rules, dividends can be distributed to family members, leading to potential tax reductions without too many restrictions.
The new rules state that dividends are subject to taxation with even high marginal rates which minimize tax advantage in return.
There are exemptions to this rule, including family members who work for the company, non-service firms and people who invest in it. The exemptions mentioned give specific people the option to collect dividends without being subject to the new regulations.
The Canada Revenue Agency (CRA) has established guidelines to identify if an individual is eligible for income splitting. Canadian taxpayers who meet these criteria may qualify:
- legally married couples
- common-law partners or unmarried couples who have lived together for at least 12 consecutive months in a conjugal relationship
- individuals who are aged 65 or older and qualified to receive pensions
- business owners where both spouses/common law partners actively contribute to the business
Age requirements and residency
The spouse or partner who will receive pension should be at least 65 years old. If under 65, the pension income may be limited to certain payments from annuities, registered pension plans or benefits linked to death.
Both partners must be residing in Canada and must have lived together for the entire tax year. However, if they’ve lived apart due to educational, medical, or business reasons, income splitting may be possible.
We mentioned previously that taxpayers can lower their tax obligations, even minimize the overall taxable income, through allocating income to family members who have lesser incomes.
There are other areas where you can apply income splitting:
1. Pension income
One of the key components of income splitting is pension income. This is where you transfer or share an income to a spouse that earns less to potentially lower both of your overall tax burden.
2. Spousal Loans
Another strategic approach to income-splitting is by lending money to the lower-income spouse or common law partner. The high-earning individual charges interest on the loan.
Although this idea may not sound so good, it serves two purposes. First, interest income on their tax return can be claimed by the lower earning spouse. Second, it redistributes the overall income which results in reduced taxes for the whole household.
Spousal loans help every couple manage their tax obligations better. In addition, it allows every couple to make the most of their finances while still abiding by the tax laws.
3. Family trusts
Income splitting does not just apply to husband or wife, it can also be distributed to other members of the family. This is where family trust comes in.
Here, income is spread out among family members with lower earnings. This allows the taxpayers to manage their tax liabilities in a strategic way. The income generated in this subset is often called “kiddie tax.”
By taking advantage of family trust, the higher-earning taxpayer can lower their collective tax obligations while ensuring that income is shared with every member of the family in a tax-efficient manner.
Income splitting serves as a valuable tax management strategy where good standing taxpayers can distribute their incomes whether for spouse or common law partners and even other family members.
But the real question is, what qualifies as the income to be able to be eligible for income splitting? The answer is, there is no threshold required to qualify. However, given that there is no required income to qualify in income splitting, the effectiveness of this tax strategic planning highly impacts when there is a high difference in the earnings between the spouses.
When one of the spouses or partners earns much more than the other, income splitting becomes more beneficial in terms of the household’s overall tax liability. However, the eligibility criteria and type of income that can be declared in an income splitting account is still more important than anything else. Because it helps in determining whether income splitting is a valuable tool and option for financial freedom of a particular household.
Aside from salary or compensation, there are still a lot of income types that are used in the economic market, but not all of them are qualified for income splitting Canada. The following are list of eligible incomes that are specified by the CRA:
1. Registered Retirement Income Fund (RRIF):
This is a type of retirement account where you can convert your registered retirement savings plan (RRSP) into a regular source of income.
The income derived from an RRIF account is not suitable for income splitting, but it also works as an effective way to balance the tax liability between the spouses.
Or if you are over 65, you could make a RRSP contribution today, transfer it into a RRIF tomorrow, then immediately withdraw it from your RRIF. This would allow you to split half of that income with your lower income spouse. I call that one immediate income splitting.— Aaron Hector, R.F.P., CFP, TEP (@AaronHectorCFP) February 17, 2021
2. Registered Retirement Savings Plan (RRSP):
The RRSP is another type of retirement savings where you contribute a pre-tax income and leave it until it grows. This account comes with a tax-free withdrawal which can also be used for income splitting.
3. Life Annuity Income:
This is a financial investment that allows you to receive a regular payout for life. If you and your spouse or partner receive income from this account, you can optimize this to enhance the overall tax situation of your household through income splitting.
Self-employment earnings, employment income and government benefits do not qualify for income splitting. That is why it is crucial for you to know the criteria and other requirements in income splitting listed on the CRA’s website so that you can make an informed financial decision.
The types of eligible income come with different amounts of funds that can be used in income splitting:
- RRIF withdrawals: up to 50% of its contribution can be used for income splitting
- Investment income: there are no specific thresholds stated under the law, but it is highly suggested to allocate a reasonable income made by each spouse.
- Business income: if you and your spouse both actively contribute to the business, which is a requirement listed by the CRA, the amount that you can split under this must reflect the total value of the contributions made.
- Rental income: the limit you can allocate for income splitting under rental income will be based upon the actual percentage of ownership. So, if one of you owns 60% of the property and the other has 40%, the income can be split in those percentages too.
- Pension income: up to a maximum of 50% can be used for splitting for incomes generated from pensions.
The answer depends on factors such as tax rates, income level of each spouse, your financial situation and how you use this tax planning strategy.
Income splitting is beneficial in reducing the overall tax liability and obligations, but it is important to understand the complexities in income splitting.
Income splitting can potentially help you with tax savings, and it’s important to know how you can leverage it to your advantage. Speak with a tax professional – they can advise if income splitting is a good strategy for you. They can also provide guidance about tax savings and make sure that you comply with the CRA’s rules and regulations.
Stay informed and be proactive in tax planning to help reduce financial stress. Read and bookmark our Best in Wealth section for the latest news on the best wealth advisors in Canada.