Income Splitting

The goal of Income Splitting is to move income from the higher-earning family member who has a higher marginal tax rate to someone who earns less and is taxed at a lower rate. This will result in big savings for the family. The main idea behind income splitting is that our tax system is based on tax brackets. The higher your income earned the more tax you'll pay on new income. Being married puts you in the position of being able to cut down your tax bill that unmarried individuals are unable to do. When you live under the same roof as your spouse, what really matters financially is how much you earn together. To increase your family's net worth is to try to reduce the overall amount of taxes you pay.

One simple method of reducing taxes you pay is to shift income from someone in a higher tax bracket to a family member in a lower tax bracket. This process, called income splitting can be a very effective way to lower your household's overall tax bill. And that, of course, frees up more money that can be used to save for your retirement, pay for education or major purchases, or just to enhance your lifestyle. Of course the government has a few rules, called attribution rules, which you must follow in order to take advantage of income splitting benefits. I can help you learn how you can reduce your overall taxes.

Methods of Income Splitting include:

1. Lend your spouse money for their investments
2. Contribute to a spousal RRSP
3. Have the higher-earning spouse pay most household bills
4. Employ your spouse in your business
5. Guarantee a loan from a financial institution
6. Lend funds to your spouse's business

1. Lend your spouse money for their investments:

The lower-earning spouse can invest the borrowed money. Because interest is charged on the loan, the capital gains, dividend income or interest income are included in the lower-earning spouse's income. Try to predict how much extra income that your spouse will earn on their investments to ensure that they stay in the same tax bracket. That way any gains are taxed at a lower rate, leaving more money for you and less for the government. The lower-earning spouse also gets a tax deduction on the interest they paid to borrow the money.

The higher-earning spouse must include the interest payments they receive in their taxable income but, you can choose the interest rate your spouse must pay. You can go as low as the prescribed rate, which is the Bank of Canada rate for the previous quarter. When you make the loan, you can lock in the interest rate for the life of the loan. Try to make the loan when you think interest rates are low.

2. Contribute to a Spousal RRSP:

There isn't any attribution unless a withdrawal from to a Spousal RRSP is made in the contribution year or the preceding two years. Attribution does not apply to annuity or minimum RRIF payments out of a Spousal RRSP.

Figure out which spouse will generate most of your family's retirement income, and then set-up a Spousal RRSP for the lower earning spouse. A Spousal RRSP is simply a special RRSP where one spouse makes contributions on behalf of the other.

The benefit of a Spousal RRSP is simple; it allows you to pay less tax. By shifting some of your household's retirement savings from the spouse with the higher income and a higher tax rate into the spouse with lower retirement income and tax rate.

Here are the essentials on just what Spousal RRSPs are, and how they work (We'll assume here that you are the spouse who will have the higher income in your retirement years).

• When you contribute to a Spousal RRSP, you get a tax deduction on your personal return. The contribution is counted along with any contributions you make to your own RRSP. The combined contributions can't exceed your total available RRSP contribution room.
• The Spousal RRSP - and any contributions made to it - are owned and controlled by your spouse.
• You must close your RRSP by the end of the year in which you turn 69. However, if you still have earned income, you still earn RRSP contribution room that becomes useable the following year. But how can you use it if you no longer have an RRSP? You can contribute to a Spousal RRSP instead, as long as your spouse is under 69!
• When money is withdrawn from the Spousal RRSP, it is included in your spouse's income, and taxed at their tax rate that should be lower than yours. However, the contributions must have been in the Spousal RRSP account for at least three years.
• If any of the funds in a Spousal RRSP are withdrawn within three years of the last contribution, that withdrawal is treated as your income, and taxed at your marginal tax rate.

3. Let the Lower-Paying Spouse Earn Investment Income

If you want to invest outside of a RRSP, consider having the higher income spouse pay for most day-to-day living expenses. This maximizes the amount of money the lower-earning spouse can invest. Because your spouse is in a lower tax bracket, any income, dividends or profits for the investments will be taxed at a lower rate.

4. Minimize Taxes on Your Investments

If you invest both inside and outside of a RRSP, you should arrange your portfolio to reduce taxes. First, to help you see why this strategy works, a few words on how different investments are taxed...

Outside your RRSP, the interest you earn on corporate bonds or GICs is taxed at the same rate as your salary (your marginal tax rate). If you have shares in a company that pays dividends or if you sell your shares for a profit (a capital gain), you are taxed at a lower rate.

Because of the lower tax rate on capital gains and dividends, it generally makes sense to hold these investments outside your RRSP. However, it's still important to look at your overall investment mix and risk tolerance when deciding which assets are held in your RRSP.

5. Have the higher-earning spouse pay the household bills

Why it works:

The strategy works to preserve the after-tax income of the lower-earning spouse. Instead of paying for household bills, the lower-income spouse can invest their funds. Any gains or income from their investments will be taxed at a lower rate. That means you get to keep more of the earnings instead of paying them to the government in tax.

How to put this strategy into action:

1. Open a separate bank account to deposit your spouse's pay to make sure it is clear where the investment money is coming from.
2. Have the higher-earning spouse pay as many household expenses as possible. You can include things like, groceries, mortgage payments, electricity, property taxes, clothing, entertainment, etc.
3. You can pay interest costs on your spouses' investment loans. Make sure you don't pay back the principal.
4. Pay your spouse's tax bill. Make sure you write the cheque directly to the government.

6. Employ your spouse in your business

Why it works?

Salary and wages are deductible business expenses when legitimate services are being performed. The income that is earned is included as employment income for your spouse. The strategy works by moving income from the spouse running the business who is in a higher tax bracket, and into the hands of a spouse who is in a lower tax bracket.

7. Guarantee a loan from a financial institution

Why it works?

The interest can be deducted against the investment income earned by the lower income spouse.

8. Lend funds to your spouse's business

Why it works?

If a loan is made to a spouse for the purpose of earning business income, the income from that business is not included in the income of the lender. However, if your spouse sells the business and generates capital gains, the gains need to be included in your income.

7. The Restrictions: Attribution Rules

You can't simply decide that income will be earned by other family members; nor can you just hand over any money or income-earning assets to another family member to take advantage of income splitting.

In many cases, if you move money or assets into the hands of another family member, the tax department will still treat any ensuing income as your income-and tax it at your marginal tax rate. The rules that govern this area are called the Attribution Rules, and even if another family member earns the income, the CCRA attributes that income to you.

Here's a summary of the major attribution rules:

• Gifts or loans to your spouse.
• Gifts or loans to an adult child.

Gifts or loans to your spouse

• If you give or otherwise shift any money, property, or investments over to your spouse, any interest profit or loss, as well as any capital gains or losses, have to be included in your tax calculations. (In other words, the gains and losses are attributed back to you.)
• There are legitimate ways around this. If you sell the assets at a fair market price to your spouse, or you lend the money or assets and charge interest, then the attribution rules don't apply.
• Gifts or loans may result in a tax bill for you.

Gifts or loans to an adult child

• If you give money or assets to an adult child (over 18 years) outright, there is no attribution. Any income or capital gains or loses affects their tax return, not yours.
• For example, you can lend money to a child to help them pay their rent while away at university.
• It's a different story with a loan. The attribution rules do apply if you lend money or assets to grown-up children with the intention of reducing your taxes.
• For instance, if you lend a grown child money so that they can buy a GIC with the idea that they will then pay little if any tax on the interest they receive, the attribution rules will kick in.