Introduction to income splitting
When it comes to preserving capital, the average investor has precious few advantages. But families looking to achieve financial independence do have some valuable weapons at their disposal to reduce tax obligations.
For those planning for retirement or recently retired there is no better practice than income splitting. Put simply, income splitting allows one person in a household to transfer a part of their taxable income or pension to a lower-income spouse. This joint election can reduce tax on that split household income — which may be up to 50 percent of the higher earner’s income.
With governments taking over half of the earned income for those at the highest tax margins, spreading out a couple’s taxable income is a key for preserving capital. For this reason income splitting — which is also known as pension splitting — has become popular not just in Canada but also in the United States. In the U.S. the practice is commonly referred to as joint-filing status where the funds of a couple are pooled and the higher-earning spouse is bumped down into a lower-income bracket.
Tips for successful income splitting
Whether beginning the process of splitting income in your 30s or 40s or starting when retirement comes in your 60s (the most common form of income splitting takes place during retirement), there are several strategies for protecting your hard-earned taxable income.
Before doing income splitting, taxpaying couples should first maximize their deductible income from RRSP and TFSA eligibility to cushion the impact of taxes today and in the future.
When TFSA and RRSP deductions are maximized, the higher-income spouse spends while the lower-income spouse saves and invests as much of their after-tax income as possible in a taxable non-registered account. Because this taxable income falls within a lower tax bracket, less tax is owed on the investment income earned, and the couple’s savings will grow faster.
To get started, CRA requires that the transferring spouse or common-law partner and the receiving spouse or common-law partner must make a joint election on Form T1032, Joint Election to Split Pension Income. This form must be completed, signed and attached to both spouse's or common-law partner's paper returns and filed by the filing due date. The information on the forms must be the same.
Pros and Cons of income splitting
At this point income-splitting can be a profitable strategy when preparing tax returns. How profitable? Here’s a sample comparison between single-earner taxation and income splitting using Ontario taxation rates. As you can see income splitting works well in this case.
Without income splitting
With income splitting
With income splitting, your total taxes are $14,226 less on an income of $150,000.
Among the issues that must be addressed before moving into income splitting are accounting costs, estate costs, transitioning to higher or lower interest rates, death of a partner and, yes, possible breakdown of the relationship in divorce or separation. Before delving into income splitting it might be wise to consult a family lawyer.
Eligibility for income splitting
In addition to earned funds, what other income is also eligible for income splitting? Old Age Security payments and Canada Pension Plan and Quebec Pension Plan payments are not eligible. Income derived from a United States individual retirement account (IRA) is also not eligible. Eligible income includes the taxable part of life annuity payments from a superannuation or pension fund or plan, annuity and registered retirement income fund (RRIF) — including life income fund payment, registered retirement savings plan (RRSP) annuity payments and certain qualifying amounts distributed from a retirement compensation arrangement.
Who can use income splitting? Any married or common-law couple in Canada can take advantage of this practice. There are also several ways in which money can be transferred to a family member who will pay at a lower tax bracket. One way to achieve this is for the higher-earning person to loan money to the lower-earning spouse or family member. The CRA has set rules that enable spouses to loan to each other at a minimum rate, known as the prescribed rate. CRA announces this rate, known widely as a Spousal Loan, quarterly, with the rate based on short-term government T-Bills.
Why is reducing the lower income earner’s tax exposure important?
The Canadian government allows every retiree with an eligible pension amount a tax credit of $2,000, also known as the Pension Income Amount. This means that the first $2,000 of your annual pension income is essentially tax-free — if you’re in the first tax bracket where earnings don’t meet the threshold for higher taxes.
Differences between Canada and USA income splitting rules
For couples with income from U.S. sources, be reminded that pension income from an IRA is ineligible for income splitting in Canada. There is a possibility of converting amounts from an IRA to an RRSP (and eventually eligible as a RRIF), but it is complicated and the juice might not be worth the squeezing.
Another note on cross-border planning. Canadian taxes are based on residency while US taxes are based on citizenship. This means that Americans living in Canada are subject to both tax regimes and must disclose assets and other personal information to the IRS even though they are Canadian residents. Canadians are subject to taxation on residency, meaning you must carefully monitor your out-of-country vacations and work opportunities to qualify for Revenue Canada.
Conclusion and final thoughts
One final note of caution for those doing long term planning using income splitting: cash-starved governments have long coveted these tax breaks as they expand their spending. As federal and provincial/ state budgets come under more debt pressure be sure to monitor your income-splitting strategies to stay one step ahead of any changes.
Income splitting is an effective strategy for families looking to achieve financial independence. It can drastically help reduce tax obligations and keep more money in your pocket.