In the U.S., couples can choose to combine their income and file a single joint tax return. But no such election is allowed in Canada where the tax rules require that every individual files a return and reports his or her own income.
The idea of splitting income with a lower-earning spouse or family member is attractive, especially in the Canadian system where higher-earning individuals are taxed at a higher rate than lower-earning ones.
Depending on the province or territory, someone with a taxable income of $100,000 a year pays $7,000 to $10,000 more in personal income tax than two people who earn $50,000 each.
The Canada Revenue Agency has long had policies in place to foil attempts to shift part of one's income to someone else. Income earned by one person must generally be claimed by that person. Attribution rules tend to nullify any attempt to "split and reduce," as it were.
But there are some exceptions to those prohibitions and taking advantage of them can result in thousands of dollars in tax savings.
Sharing pension income
|Type of income||Application frequency||Age limits|
|Company pension||Every year||No limits|
|RRIF income||Every year||65 and older|
|RRSP annuity||Every year||65 and older|
|CPP benefits||Once||Both partners 60 and older|
|Old Age Security||No splitting||N/A|
For more than a decade, Canadians have been able to share their Canada Pension Plan retirement income. So, if one spouse has a CPP pension of $600 a month and the other, $200, it's possible to share so each would have a monthly CPP payment of $400.
If only one person gets a CPP retirement pension, it can be divided in half with the other spouse.
This kind of sharing arrangement is available to spouses and partners who are each at least 60 years old. Eligible pensioners must apply for the assigning of benefits, as it's called, but only need to do so once.
Once it's set up, CPP cheques are adjusted to be equal, and the sharing will continue as long as the relationship does. You can learn more about CPP sharing at the Service Canada website.
Other pension splitting
On Oct. 31, 2006, Ottawa announced it would allow a variety of pension income sources to be split, though the news was buried by the simultaneous announcement that income trusts would soon face new taxes.
Still, two million pensioners suddenly found they could save hundreds or even thousands of dollars by sharing much of their retirement income.
"Pension income splitting can be a gigantic benefit for people," says Keith MacIntyre, a tax partner with Grant Thornton in Halifax. "It can save retirees a considerable amount of money."
Have the higher-income spouse or common-law partner assume most or all of the personal household expenses, leaving the person with the lower income with as much disposable income as possible to invest.
Source: Grant Thornton's Tax Planning Guide 2011-2012
MacIntyre says software programs can maximize the split for you. Or you can hire a tax professional.
Another element from that 2006 announcement was that life annuity payments from a company pension plan can be split with one's spouse or partner, no matter how old the person who is getting the pension is.
For those over 65, additional sources of pension income can also be split. That includes RRIF payments and annuity payments from an RRSP or deferred profit-sharing plan.
To split these kinds of pension income, both partners must file a joint election — form T1032.
Unlike the case with the sharing of CPP retirement benefits, both partners have to file this form every year in which they want to split pension income. So, each year, both partners will have to sit down and decide whether they want to split and to what extent they want to split.
There are several benefits to splitting pension income besides the obvious one that comes from shifting income from someone in a higher tax bracket to someone in a lower bracket.
The split can sometimes reduce or eliminate the clawback on Old Age Security payments or the age credit for the higher-income spouse. Further tax savings appear if both partners can claim the $2,000 pension income credit.
Big earners have long tried to give some of their income to a lower-earning spouse, in order to have any income earned by that money taxed at a lower rate. Those efforts usually fail because of the CRA's strict attribution rules.
Attribution rules do not apply to payments your family receives under the child tax benefit program, including universal child care benefits payments for all children under age six and child disability tax benefit payments. As a result, you can direct these payments to an in-trust bank account for your child so that the investment income earned on these amounts will be taxed in your child's hands.
There is, however, a way to do this legally but it involves paperwork. Basically, you have to loan the money, instead of giving it.
You must also charge interest that's at least equal to what's called the CRA's prescribed rate.
Currently, that rate is just one per cent. That's right, one per cent. That goes a long way to explain why spousal loans have become so popular lately.
If your spouse is in a lower tax bracket, the lent money has only to make a return greater than one per cent for the couple to end up with a lower overall tax bill.
Also, "you can lock in this one-per-cent rate for the life of the loan," says Deborah MacPherson, a partner with KPMG Enterprise in Calgary.
That means that the loan rate can stay at one per cent indefinitely. But this spousal loan strategy must be structured and documented like a real loan. "It needs to be documented and interest needs to be paid," MacPherson points out.
The lower-income spouse must pay that interest every year, or by Jan. 31 of the following year. Failure to make that payment will cause the attribution rules to apply, and the income generated by the lent money for that year and all future years will be attributed back to the lender.
The interest paid has to be reported by the lending spouse as income, but it may also be claimed by the borrowing spouse as a deduction.
"Consider spousal investment loans if you are the higher income spouse and the investments are in your name as a result of an inheritance or accumulation of assets," says James Gustafson of Gustafson Accounting in Victoria.
Hiring your spouse or child
Business owners have another option for income splitting. They can hire their spouse or kids to work in the business. But before you hire your two-year-old as an "adviser" and your four-year-old as a "consultant," know that there are rules in place here to prevent abuse.
"The work actually has to be performed, and the payment has to be reasonable," says Evelyn Jacks, author of Essential Tax Facts and president of the Winnipeg-based Knowledge Bureau.
By "reasonable," Jacks means that the pay must be what you'd pay a typical outsider for similar work. So, a $200,000 salary for your teenage daughter to be your receptionist wouldn't pass muster.
The work must also be completely documented, with normal payroll deductions made and T4 slips issued.
This strategy works with both incorporated and unincorporated businesses.
Incorporated business owners, however, have another income-splitting opportunity. They can give their spouse or adult children dividends. That can result in a big tax savings over having the owner take all the dividends.
Given that CPP and other pension income can now be shared or split, some may wonder if it still makes sense to contribute to a spousal RRSP. The experts say yes.
"Spousal RRSPs can still be a valuable planning tool and are a hedge against future changes in the pension-splitting rules," says accountant James Gustafson.
Jacks also notes that there are age limitations on pension splitting. For instance, a spouse must be over 65 to split an RRIF annuity payment with the lower-income spouse. "It's still absolutely necessary to have a spousal RRSP," she says. "The goal is to have equal amounts of capital at any age."
Just be aware of the main rule for spousal RRSPs: If amounts are withdrawn from a spousal RRSP in the year the contribution is made or in either of the next two calendar years, the income will attribute back to the contributor.
Tax-free savings accounts
About 10 million Canadians have already set up tax-free savings accounts. Since these are funded with after-tax income, there's nothing wrong with the higher-income spouse giving the lower-income spouse or adult children $20,000 each for their TFSAs (provided they have the contribution room).
All the income earned in a TFSA is tax-free, so there are no attribution worries.