Income splitting: it's not just for seniors
Reducing tax burden can be a family affair
The tax department has anticipated that some people might think this unfair. As a result, 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.
Canadians have been able to share their Canada Pension Plan retirement income for more than a decade. So, if the higher-income spouse has a CPP retirement pension of $600 a month and the other has a CPP pension of $200, it's possible to share it so both would have a monthly CPP payment of $400. If only one person gets a CPP pension, it can be divided in half with the other spouse.
Splitting pension income
|Type of income||Application frequency||Age limits|
|Company pension||Yearly||No limits|
|RRIF income||Yearly||65 and over|
|RRSP annuity||Yearly||65 and over|
|CPP retirement benefits||Once||Both spouses or partners 60 or older|
|Old Age Security||No splitting allowed||N/A|
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 other pension income sources to be split, too. This news was buried by the simultaneous announcement that income trusts would soon face new taxes — the so-called Halloween massacre. Two million pensioners suddenly found they could save hundreds or even thousands of dollars by sharing a lot of their retirement income.
As of that 2006 announcement, life annuity payments from a company pension plan can be split with one's spouse or partner, no matter how old the person who's getting the pension is. For those over age 65, other 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 with CPP splitting, both partners have to file this form every year 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.
People have long tried to give their lower-income spouses money and tried to have all the income earned by that money taxed in their spouse's hands. Those efforts usually fail because of the aforementioned attribution rules.
There is, however, a way to do it that won't attract the corrective attention of the tax department. Basically, it involves paperwork.
Arrange your financial affairs so that the spouse or partner who earns the higher income is paying as much of the family's living expenses as possible, allowing the other one to save and invest.
|Source:Ernst & Young's Managing Your Personal Taxes 2010-11|
You have only 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. You read that 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.
Not only that, but the prescribed one per cent rate can be in effect for the life of the loan — five years, 10 years, even 20 years or longer. Even if the prescribed rate goes up in the next quarter (which it probably will), the loan rate can stay at one per cent indefinitely. We mentioned paperwork. This spousal loan strategy must be structured and documented like a real loan.
The lower-income spouse must pay the 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.
"I most commonly recommend [spousal loans] when one spouse has recently received an inheritance and wishes to invest it but is the higher income earner," 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.
Attribution rules do not apply to payments your family receives under the child tax benefit program, including universal child care benefit payments for all children under the age of six. 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.
|Source: KPMG's Tax Planning For You and Your Family 2011|
"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's receptionist skills 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 major tax savings over having the owner take all the dividends.
"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 less than three years after the contribution is made, the income will attribute back to the contributor.
Tax-free savings accounts
More than five 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 $15,000 each for their TFSAs (provided they have the contribution room).
All the income earned by a TFSA is tax-free, so there are no attribution worries.