Income splitting is a tax-saving strategy that many Canadians use to reduce their overall tax burden. But what is income splitting, and how can it help you save money? This guide breaks down income splitting in Canada, the potential savings it offers, and the options available for families and business owners.
What is Income Splitting?
Income splitting involves transferring income from a higher-income spouse to a lower-income spouse or family member. Canada’s progressive tax system taxes higher earners at higher rates. By sharing income among family members in lower tax brackets, families can reduce their overall tax liability.
Who Benefits from Income Splitting?
Married Couples or Common-Law Partners: Couples with significant income differences benefit the most. If one spouse is in a higher tax bracket and the other has little or no income, income splitting can lower the overall family tax bill.
Retirees: Retired couples can benefit from pension income splitting. A higher-income spouse can transfer up to 50% of eligible pension income to a lower-income spouse, reducing the couple’s total tax.
Families with Children: Some families can use income splitting by setting up a family trust or sharing dividends from a family business.
Methods of Income Splitting
Several methods of income splitting are available in Canada. Here are the most common ones:
Pension Income Splitting:
- Eligibility: Retired Canadians receiving eligible pension income.
- How It Works: You can transfer up to 50% of eligible pension income to your spouse, which may lead to significant tax savings.
Spousal RRSPs:
- Eligibility: Anyone looking to split income during retirement.
- How It Works: The higher-income spouse contributes to a spousal RRSP. Withdrawals in retirement are taxed in the lower-income spouse’s hands.
Dividends from a Family Business:
- Eligibility: Business owners who want to share income with family members.
- How It Works: Income can be shared with family members who hold shares in the business, following certain rules to avoid tax avoidance.
Family Trusts:
- Eligibility: Families with significant investments or businesses.
- How It Works: A family trust can distribute income to beneficiaries in lower tax brackets, reducing the overall tax burden.
Rules and Limitations
Income splitting can lead to tax savings, but it’s essential to understand the rules and limitations set by the Canada Revenue Agency (CRA).
Attribution Rules: The CRA’s attribution rules prevent income splitting by attributing income back to the original earner in some cases. For example, if a higher-income spouse gives money to a lower-income spouse to invest, the income earned may be attributed back to the higher-income spouse.
Tax on Split Income (TOSI): The TOSI rules apply to certain types of income from a business received by family members. These rules aim to prevent income splitting where family members are not actively involved in the business. If TOSI applies, the income is taxed at the highest marginal rate, negating the benefits of income splitting.
Eligible Income: Not all income types qualify for income splitting. For example, salary and wages from employment cannot be split between spouses. Pension income, dividends, and specific investment income typically qualify.
Potential Savings and Examples
Here are some examples to illustrate potential savings from income splitting:
Pension Income Splitting for Retirees:
- Scenario: John receives $60,000 per year in pension income, while Mary receives $20,000. By splitting John’s pension income, they reduce their tax bill by taking advantage of Mary’s lower tax rate.
- Savings: Depending on their province and other income, they could save thousands of dollars annually in taxes.
Spousal RRSP:
- Scenario: Robert, in a higher tax bracket, contributes $10,000 to a spousal RRSP in Susan’s name. When Susan retires, she withdraws the funds at a lower tax rate.
- Savings: By shifting the tax burden to Susan, who is in a lower tax bracket, Robert and Susan can achieve significant tax savings over time.
Is Income Splitting Right for You?
Income splitting offers significant tax savings, but it may not suit everyone. The benefits depend on your financial situation, income levels, family structure, and future goals. Consulting a financial advisor or tax professional is crucial to determine if income splitting is right for you and to ensure compliance with CRA regulations.
Conclusion
Income splitting is a powerful tool for reducing your tax burden in Canada, but it requires careful planning and an understanding of the rules. Whether you’re a retiree optimizing your pension income, a business owner sharing dividends, or a high-income earner contributing to a spousal RRSP, income splitting could save you money and enhance your family’s financial well-being.