Income splitting

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Income splitting is a tax strategy to reduce family taxes by shifting income from high income earners to low income earners and takes advantage of the different tax brackets that exist in Canada. Canadian tax rules require that each individual file their own tax return and report their own income. This differs from the US tax system where couples can combine their income and jointly file a tax return.

By splitting income, the high income earner can reduce their net income and taxable income. This has the following benefits[1]:

  • reducing the taxpayer's marginal tax rate (and possibly increasing the spouse's marginal rate)
  • reducing or eliminating Old Age Security clawback
  • creating a pension tax credit for the spouse (with pension splitting)

The Income Tax Act (ITA) contains a set of attribution rules that prevent family members from transferring assets between themselves for the purpose of avoiding taxation. Most of the attribution rules are located in sections 74.1 to 75 of the ITA. IT511R - Interspousal and Certain Other Transfers and Loans of Property discusses a comprehensive set of rules intended to prevent a taxpayer and the taxpayer's spouse from splitting income from property so as to reduce the total amount of tax payable on that income.

Nevertheless, some income splitting strategies are available to Canadians and are described in this article. This includes splitting pension income on a couple's tax return; shifting assets to a spousal RRSP; giving the other spouse money for their TFSA; making a spousal loan at prescribed rates; having the higher income spouse pay most household expenses so the other spouse keeps more money for investing; and sharing CPP/QPP pensions.

Pension income

Canadian residents may split up to 50% of eligible pension income[2] with their resident spouse or common-law partner as of the 2007 tax year. Note that "eligible pension income" has strict definitions and does not include all types of pension income.

What is eligible pension income?

Eligible pension income includes regular payments from a workplace pension, at any age.

Starting at age 65, eligible pension income includes RRIF and LIF withdrawals, annuity payments, but not lump sum RRSP withdrawals.[3][4]

Amounts such as OAS, CPP/QPP, death benefits, and retiring allowances do not quality for splitting. However, CPP and QPP can be shared, see below.

How splitting works

You (the pensioner) and your spouse or common-law partner (the pension transferee) must make a joint election on Form T1032, Joint Election to Split Pension Income.

  • If you are filing electronically, keep this form in case CRA asks to see it later.[5]
  • If you are filing a paper return, this form must be completed, signed and attached to both your and your spouse's or common-law partner's paper returns by your respective filing due date.[6]

No actual funds are transferred when splitting pension income, it is bookkeeping entries on your respective tax returns. Only one joint election can be made for a tax year.[7]

Conditions

Taxpayers can only qualify for splitting pension income if certain conditions are met, including having recieved income that qualifies for the pension tax credit during the year.[8]

Pension income tax credit

Separately from the pension income splitting opportunity, taxpayers can report a "pension income amount" on line 31400.

This is a non-refundable federal tax credit of 15% is available on the first $2000 of eligible pension income.[4][9]

This means that if one spouse has eligible pension income and the other does not, up to $2000 of eligible pension income can be reallocated so that both spouses obtain the tax credit.[10] Note that the age of the receiving spouse matters here: if the spouse is less than 65 year old, the types of pension income considered eligible are more restricted.[10]

Spousal RRSPs

You may want to set up a spousal or common-law partner Registered Retirement Savings Plan (RRSP). This type of plan can help ensure that retirement income is more evenly split between both of you. The benefit is greatest if a higher-income spouse or common-law partner contributes to an RRSP for a lower-income spouse or common-law partner. The contributor receives the short term benefit of the tax deduction for the contributions, while the annuitant, who is likely to be in a lower tax bracket during retirement, receives the income and reports it on his or her tax return.[11] There is a three-year restriction on the owner of a spousal RRSP making a withdrawal. This is based on calendar years, not the three years from the last contribution.[12]

A spousal/partner RRSP is eventually converted to a spousal/partner RRIF, and withdrawals are taxed in the annuitant's (the lower income spouse) hands, instead of the contributor's hands.

Although the introduction of pension income splitting can seem like it made spousal/partner RRSPs irrelevant, this is not the case if:[13]

  • You want to make RRSP withdrawls before age 65
  • You want to split more than 50% of that income

Tax-Free Savings Accounts

Unlike the rules for Spousal RRSPs, you can provide money for a spouse or common-law partner to contribute to their own Tax-Free Savings Account (TFSA) without having that amount, or any earnings from that amount being attributed back to you.[14] Your spouse or common-law partner should ideally make the TFSA contribution from their bank account as some financial institutions will not accept funds when the sending party name does not match the name of the TFSA.[15]

The strategy described here does not help directly with equalizing taxable income during retirement (since TFSAs don't attract tax). However, since the higher-income spouse is paying both TFSA contributions (or at least helping the lower-income spouse), the lower-income spouse will have more money available to invest in their RRSP (up to the allowed limit) or in a non-registered account.

Spousal loans

Spousal loans are loans between family members at the Canada Revenue Agency's prescribed rate[16]. The interest rate charged can be fixed for the duration of the loan, which offers a tax planning opportunity when interest rates are low. The loan must be properly documented with a promissory note or loan agreement and actual funds must be shown to have been exchanged when the loan is created and when interest payments are due. The interest must be paid at least annually, with record kept of the payment.

Managing household expenses

Once the TFSAs and RRSPs are full, additional savings often go to non-registered accounts. It would be better for tax-purposes if the lower-income spouse built at least some non-registered savings, rather than having the higher-income spouse do all the non-registered investing. This is when managing household expenses can help.

"The higher-earning spouse’s income can be used to fund the expenses of daily living, while the lower-earning spouse’s income is saved. All gains, interest and other income is thus taxable in the lower-earning spouse’s hands."[17]

A counter-argument is that the lower-earning spouse may feel more "independent" if assuming a share of the household expenses: "In two-income families, the sharing of expenses gives a certain equality to the spouses and a sense of independence to the lower-income spouse."[18] A rational discussion between spouses on the financial benefits of income splitting should overcome such ideas. Buy $500 worth of food or gasoline now, and in a few weeks/months, nothing is left. Buy $500 worth of stocks and bonds, and hopefully they’ll be worth double that in ten years. Isn’t that better for one’s sense of independence?

The higher-earning spouse can even pay the other spouse's taxes.[19]

Tax expert Jamie Golombek recommends that if the strategy of having the higher-income earner pay more expenses is used, the couple should keep good records of income and expenses, "in case you ever have to prove to the Canada Revenue Agency (CRA) how the lower-income spouse or partner obtained funds for investment".[13] This might be easier to document with "separate bank and investment accounts, rather than having joint accounts".[13]

Sharing CPP or QPP

Pensions from CPP/QPP do not qualify for pension income splitting on one's tax return, as mentioned above. However, when you start claiming CPP or QPP, you can ask to "share" your pension with a spouse or common-law partner.[20][21] The nuance between splitting and sharing is as follows: with pension splitting, no funds are actually transfered, it simply consists of allocating income to the other spouse on tax returns. With CPP/QPP sharing, the amounts actually paid by CPP/QPP to each spouse will change: the total amount recieved will be the same, but the division between partners will be more equal.

How much can be shared depends on "the number of months you and your spouse or common-law partner lived together during your joint contributory period". This may result in tax savings.[22] You only need to apply once, not every year. The pension sharing arrangement can be cancelled at any time, and stops upon death of a spouse/partner.

See also

Further reading

References

  1. ^ TaxTips.ca - Income splitting, viewed August 21, 2012.
  2. ^ Canada Revenue Agency, Eligible pension income, viewed July 28, 2017.
  3. ^ Canada Revenue Agency, Can you claim the pension income amount?, viewed December 12, 2021. Note that the list of eligible pension income includes box 16 from the T4RSP slip, but that consits of annuity payments, not lump sum withdrawals.
  4. ^ a b TaxTips.ca, Line 31400 Pension Income Amount Tax Credit, viewed December 12, 2021.
  5. ^ Canada Revenue Agency, Form T1032 Joint Election to Split Pension Income, viewed December 14, 2021.
  6. ^ Canada Revenue Agency, How do you split your pension income?, viewed July 28, 2017.
  7. ^ TaxTips.ca, Pension Income Splitting, revised November 28, 2021, viewed December 13, 2021.
  8. ^ Canada Revenue Agency, Eligible pension income, viewed December 12, 2021.
  9. ^ MoneySense, Understanding the pension income tax credit, January 15, 2014, viewed December 12, 2021.
  10. ^ a b RBC Wealth Management, Pension income splitting, June 2016, viewed December 4, 2022.
  11. ^ Canada Revenue Agency, Setting up an RRSP, viewed August 21, 2012.
  12. ^ Canada Revenue Agency, Withdrawing from spousal or common-law partner RRSPs, viewed August 21, 2012.
  13. ^ a b c Jamie Golombek, The great divide: Income splitting strategies can lower your family’s taxes, December 2020, viewed December 14, 2021.
  14. ^ Canada Revenue Agency, TFSA Contributions, viewed January 11, 2016.
  15. ^ Financial Wisdom Forum post: "TFSA 2016", by Quebec, viewed January 11, 2016.
  16. ^ Canada Revenue Agency, Prescribed interest rates, viewed August 21, 2012.
  17. ^ Alexandra Macqueen, "A Primer on Family Income Splitting", Canadian MoneySaver, June 2009, p. 30-33 (subscription required)
  18. ^ Caroline Nalbantoglu, "Income Splitting", Canadian MoneySaver, Nov/Dec 2006, p. 32-33 (subscription required)
  19. ^ BDO Canada LLP, Income Splitting, June 20, 2012, viewed December 14, 2021.
  20. ^ Employment and Social Development Canada, Pension sharing, viewed December 13, 2021.
  21. ^ Retraite Québec, Retirement pension sharing between spouses, viewed December 13, 2021.
  22. ^ TaxTips.ca, Sharing CPP Pension With a Spouse, revised October 28, 2021, viewed December 13, 2021.

External links

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