Income splitting is a tax strategy that involves transferring income to a family member (usually a spouse or common-law partner) to reduce taxable income.
With income splitting, you can transfer a part of your income to your spouse or common-law partner if you are in a higher income tax bracket than they are.
You can use the income split strategy before and after retirement to minimize your tax payable.
How to Split Income
You can split your income for tax purposes using pension income splits, spousal RRSP contributions, TFSA contributions, and spousal loans.
Pension Income Split
If you have a higher tax bracket and receive eligible pension income, you can jointly elect to allocate part of your pension income to your spouse or common-law partner.
In this case, you are the transferring spouse or common-law partner.
Your spouse or common-law partner is the receiving spouse or common-law partner.
You can transfer up to half (50 percent) of your eligible pension income to your spouse or common-law partner.
To split your pension income, you and your spouse need to make a joint election on Form T1032, Joint Election to Split Pension Income.
You are both required to submit this form when filing your tax return.
Spousal Registered Retirement Savings Plan
The Canada Revenue Agency allows you to contribute to your spouse’s or common-law partner’s RRSP as long there is available contribution room.
While you can claim the RRSP deduction on your tax return, the CRA will tax RRSP withdrawals at your spouse’s or common-law partner’s tax rate in retirement.
This tax strategy is effective if your spouse or common-law partner has a lower tax bracket in retirement.
If you are in a higher income tax bracket, income splitting is not as straightforward as giving your spouse or common-law partner money to invest for capital gains or investment income.
In this case, the CRA will deem such a transfer as an attempt to reduce your tax payable.
The CRA will tax investment income and capital gains from such investments using your higher tax rates.
However, to avoid getting taxed at your higher tax rate, you can give your spouse (with the lower tax rate) a spousal loan.
The CRA will recognize this transfer of money as a loan only if you charge your spouse or common-law partner an interest rate that is not lower than the CRA prescribed rate and a similar market rate, whichever is the least.
Also, for the CRA to consider a money transfer to your spouse or common-law partner as a loan for investment purposes, your spouse should pay the annual loan interest within 30 days after the end of every year that the loan is in effect.
If your spouse or common-law partner does not pay the loan interest within 30 days after the year-end, the CRA will tax any income or capital gains from an asset that your spouse purchases with the loan at your tax rate.
Tax-Free Savings Account (TFSA)
The CRA allows you to give your spouse or common-law partner money to contribute to their TFSA.
Using the tax-free savings account for income splitting is beneficial since individual contributions to a TFSA are limited.
While you can invest in a non-registered account, half of your capital gains will be taxable.
If you do not have any more TFSA contribution room, you can give your spouse or common-law partner money to save and invest through their TFSA, provided they have unused contribution room.
Any investment income or capital gains they make through the TFSA will not be taxed.
Benefits of Income Splitting
An income split between spouses is beneficial for effective household tax management.
If one of you are in a higher marginal tax bracket, shifting a portion of income to the lower-earning spouse can reduce the overall tax payable.
Income splitting allows couples to transfer income from one party to the other in a bid to equalize their taxable income.
For example, assuming you have a marginal tax rate of 26% and your spouse or common-law partner has a lower income tax rate of 15%.
If you invest $100,000 and make capital gains of $5,000, the CRA will tax half of this capital gain ($2,500) at your marginal tax rate of 26%.
Your capital gains tax can amount to $650.
However, if you give your spouse or common-law partner the $100,000 as a spousal loan at an interest rate of 1% (the applicable prescribed interest rate), the CRA will tax half of the $5,000 capital gain ($2,500) at your spouse’s lower marginal tax rate of 15%.
Your spouse’s capital gains tax can amount to $375.
In this example, that is $275 ($650 minus $375) in tax savings, however this is just to show you what’s possible and savings can become material as the numbers become larger.
Remember that you need to report the 1% interest charge that your spouse or common-law partner pays for the spousal loan.
The good part is your spouse can claim interest charges for investment purposes when filing a tax return for the year.
Using an income split may become complicated.
You may need to engage the services of an accountant to ensure that you are attaining substantial tax savings.
You also need to keep adequate documentation of your income split.
Frequently Asked Questions
- Who qualifies for income splitting?
You can split income with a family member such as your spouse or common-law partner before and after retirement using allowable strategies for specific situations. In some instances, you can also split income with your adult child.
- Do both spouses have to be 65 to income split?
You can practice income splitting at any age with your spouse or common-law partner. There are eligible pension income sources that you can split with your spouse or common-law partner if you are younger or older than 65 years of age.