Earn more, pay more. That’s the outcome of the Canadian graduated tax system. It doesn’t, however, have to be the only inevitable outcome. You may be able to take advantage of income splitting with your spouse or partner who incurs a lower tax rate because they earn less than you or have no income. As an entrepreneur, dentist or health professional, effective income redistribution will allow you to save more as a family.
With the right tax planning and wealth management strategies, including income splitting, you can look forward to keeping and being able to enjoy more of your hard-earned income.
What Is Income Splitting and Why Should You Use it?
Per the Canada Revenue Agency (CRA), you and your spouse or common-law partner cannot file joint income tax returns. However, Canada has a progressive or graduated income tax system. Income splitting is a useful strategy that involves dividing a part of your income (up to 50 percent) with your family members who earn a considerably lower income than you. The logic behind income splitting is to reduce the taxable income of the family.
Who Is Eligible for Income Splitting in Canada?
You and your spouse/common-law partner can split your income with each other or invest/gift a part of your income to your family members including minor child/children, or adult child/children. To be eligible for income splitting, you must be legally married or have a common-law partner. If you are in a common-law relationship, the CRA must be informed within 30 days of the arrangement to be recognized. You must also live together in Canada during the appropriate tax year. However, certain exceptions are allowable based on medical, educational, or business grounds.
How Does Income Splitting Work?
Below are seven simple and effective income splitting strategies that you can use in Canada. However, there are other strategies that may apply to your unique situation. That’s why it’s important to work with a tax professional who can advise you and help you maximize your tax savings.
1) Spousal RRSP (Registered Retirement Savings Plan) contribution
A spousal or common-law partner RRSP allows you to split up to 100 percent of what you earn with your partner or spouse. Thus, the higher income-earning spouse/partner can contribute more to the RRSP each year than the lower income-earner. This makes sense if your spouse/common-law partner is earning a substantially lower income than you and will continue to do so when you both retire as the spousal RRSP can help level the savings in retirement for you both. The more evenly distributed retirement income will be taxed at a lower rate.
2) Prescribed Rate Loan to Spouse or Partner
Prescribed Rate Loan allows for income splitting whereby a higher-earning spouse/partner gives a part of their income as a loan to his/her considerably lower income-earning spouse/partner. It is also significantly beneficial if there are substantial funds available to lend and invest.
- There must be a written loan agreement between the two parties.
- The loan interest rate is set when the loan agreement is made. It is charged based on the CRA’s prescribed quarterly interest rate and an arm’s length (commercial rate), whichever is lower.
- The borrower can then invest the funds to earn income or capital gains.
- For attribution rules to not apply, the loan interest needs to be paid on or before January 30th of each year.
- The loan interest must be included in the lender’s taxable income. The borrower can claim a deduction for the interest while including the income and capital gains or losses in their income.
3) Splitting Income with Children
There are a few different ways to split income with your children, as explained below.
You can invest a part of your income on behalf of your minor child (including grandchild, nephew, or niece under 18 years of age) by opening an in-trust account at your bank/financial institution. Though you will pay taxes on the interest and dividends generated by that investment, capital gains can be taxed or claimed in the hands of the unemployed and non-salaried child.
Gifting to Your Adult Child
You can gift a part of your income in the form of cash or assets to your adult child (over 18 years of age). The attribution rule is not applied when you give cash or assets to an adult child. You will not have to pay any taxes on dividends, interests, or capital gains resulting from the gift.
Loan to Adult Child
You can also give a loan to an adult (over 18 years old) child/children to help them purchase their house. You don’t need to charge interest if the child plans on staying in the house and does not plan to use it for investment purposes. This will be deemed as a gift and attribution rates will not apply.
However, if your child wants to earn an income from the house by renting it out, you need to treat it as a loan and charge your child interest at the prescribed rate (or higher), or else you will be taxed on the income generated from the rent as it will be attributed back to you. You must declare your interest-bearing loan on your tax return.
4) Loan to Family Trust
A family trust is an agreement by the members (family members – typically spouses, and children) to hold assets for someone’s benefit, used mainly for income splitting purposes for reducing taxes. The settlor, a third party creates the trust for the trustee/s (who control the trust) and the beneficiaries (who receive income and assets from the trust). The trust earns income which is allocated to the different beneficiaries for tax purposes.
You can use the spousal/partner loan strategy (explained in point 2 above) to help fund expenses for your children if you make a prescribed rate loan to a family trust. Lending money to a family trust is helpful especially when it involves minor kids as beneficiaries, as payments can be made to them or to their benefit. The trustee/s invests the funds and pays net investment income to the children directly or for their benefit after deducting the interest on the loan and by paying certain expenses. This income can be received tax-free if the children have very little or zero income.
5) TFSA (Tax-Free Savings Account)
You can gift money to your partner/spouse or child/children or grandchildren (if they are at least 18 years of age) to help contribute money towards their TFSA. The TFSA contribution limit for the year 2023 is $6,500. The income earned through this method, or any capital gains, will not be attributed back to you if the funds remain in the TFSA. Though you don’t get the same tax deductions as you would in a Spousal RRSP, your spouse/partner, child, or grandchild can benefit from tax-free investment income and save for their future.
6) Pension Splitting
Per the CRA guidelines, you are allowed to allocate up to 50% of eligible pension income with your spouse or common-law partner if you both are at least 65 years old, living together for at least one year, and have not separated for more than 90 days. For this, a Joint Election to Split Pension Income form needs to be filled out by you when you’re filing your personal tax returns.
7) Higher Income-Earner Pays All Expenses
Another strategy is for the higher-income earning spouse or partner to fund all expenses related to the household like mortgage payments, food, and clothing amongst others, and the lower income-earner saves all their income or uses it for non-registered investing. The higher income-earner can also pay for their partner’s or spouse’s taxes. This helps ensure that the total family income is taxed at the lowest possible rate.
Save More with Income Splitting Strategies
While income splitting in Canada is a great way to help alleviate your tax burden, the CRA’s taxation rules are complex. To be able to choose the best income tax saving method, you need to evaluate the various income splitting strategies, understand their tax implications, and be aware of their limitations. Get in touch with reputed wealth and tax management specialists who are well-versed in your professional field. They will understand your challenges and aspirations individually and as a family, to help you choose the right income tax saving strategy that suits your needs.
The St-Georges Group provides wealth management services to dentists, health professionals, entrepreneurs, and high-net-worth individuals and families. Our tax planning strategies include proven tax-saving methods such as income splitting. Browse our website for more information on all the wealth management strategies we offer.
Additional Readings You May Find Interesting