How to use Income Splitting to Save Money in CanadaJanuary 23, 2024
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In Canada, in order to reduce your income tax, you can do something called income splitting. Income splitting allows you to reduce your household annual income by only claiming part of your income while your spouse or common-law partner claims the rest of your income. Unfortunately, though, this practice is only available to married couples or those with common-law partners receiving eligible pension income. Let’s look at how spousal income splitting works.
The Process of Income Splitting
In Canada, the most common form of income splitting for tax purposes is used for retirement income. This tax strategy involves the high-income earners allocating income to the lower-earning income to reduce the overall tax obligations. How does this work, though, if the total net income is the same?
Well, what pension income splitting is going to do is reduce the tax bracket of the higher-earning spouse. In turn, this will raise the tax bracket of the lower-earning spouse. Overall, this may increase the tax of the lower-income spouse, but it will significantly reduce the income of the other spouse. This is because, in Canada, we have a progressive tax system. This means that the more you make, the more tax you pay. Unfortunately, though, it’s not available for all forms of income.
It’s also important, when considering income splitting, to be informed of Canadian tax laws and regulations. There are rules involved with income splitting to prevent Canadian taxpayers from artificially using income splitting for tax savings. If you’re unsure yourself, you can always speak to a tax professional who can help you with income splitting and how to do it properly.
Income that Qualifies for Income Splitting
When considering income splitting, it’s important to know what type of income is eligible. In Canada, you can split your income into any RRIF (Registered Retirement Income Fund), RRSP (Registered Retirement Savings Plan), and life annuity income. The complex part starts when you figure out how and when to split that income.
Income Splitting RRIF
Registered Retirement Income Funds are just one of the types of income that you can income split in Canada. Essentially, an RRIF is the income you receive from your RRSP once you hit retirement age. Once you turn 65 and start receiving your RRIF income, you can split that income with your spouse and reduce your overall tax bill. You can split up to 50% of your contributions.
Income Splitting RRSP
When it comes to RRSPs, you can split the retirement income in order to save money. That said, though, you can also use RRSPs to save money before you reach retirement age. While this method isn’t technically income splitting, it is a way to use your income to reduce your overall tax burden by using a spousal RRSP for retirement savings.
A spousal RRSP works by allowing you to allocate some of your income to an RRSP in your spouse's name. Since there’s a limit to how much you’re able to contribute to your RRSP annually, some who make more than their spouse choose to contribute not only to their own RRSP but to their spouses as well. Not only does this reduce your taxable income while you are still employed, but it will make it so your retirement income is even when you retire, putting you and your spouse in the same tax bracket instead of different tax brackets. It’s a good strategy for retirement planning.
Income Splitting Life Annuity Income
Life annuity incomes are financial investments that allow you to receive regular payments for life. Any income you receive as life annuity income can be used for income-splitting purposes.
Alternative Ways to Split Income
The ways we listed above aren’t the only ways in Canada to split your income. Here are a few more strategies that can help you reduce your overall tax burden.
While government benefits like the Canada Pension Plan and Old Age Security income aren’t eligible income for income splitting, your standard pension plan payments are. You can allocate up to 50% of your pension income to your spouse.
While this isn’t a common strategy, one way to help reduce your overall income is with spousal loans (lending money to your spouse). How this works is the higher-earning partner lends money to the lower-earning spouse at the prescribed interest rate of the CRA. The higher-income spouse then charges interest on the loan. These interest payments can be claimed as interest income on the lower-earning spouse's income taxes, reducing the overall household income. Having a loan agreement with your spouse isn’t for everyone. Depending on your financial situation, you could benefit from the tax savings.
In the case of family trusts, you can actually split your income between other family members, not just your spouse. A family trust allows you to split your income between lower-income family members in a tax-efficient way. You can reduce your income while ensuring that your family income increases.
Income Splitting Before the Age of 65
While the majority of income splitting starts during retirement, at the age of 65, depending on your individual financial situation, you can split your income before the age of 65. Family trusts and spousal loans can be done at any age. Plus, if you retire before the age of 65, you can start splitting that pension income. Any rental income, investment income (such as mutual funds), capital gains, or business income that you want to split can also be made before the age of 65.
CRA(Canada Revenue Agency) Income Splitting Rules
On top of making sure the income you’re splitting is eligible, there are some requirements that you need to meet in order to be eligible under attribution rules from the federal government. These are:
- You received pension income that qualifies for the pension income amount, or you were 65 and received certain amounts from retirement compensation.
- You and your spouse lived in Canada on December 31 of the tax year.
- You and your spouse lived in Canada until the date of death, if deceased in the tax year.
- You and your spouse lived in Canada on December 31 of the tax year if you were bankrupt in the year.
- You and your spouse were not separate due to the breakdown of a marriage at the end of the tax year and for a period of 90 days or longer beginning in the tax year.
If you were living apart from your spouse due to medical, educational or business reasons, then you still qualify.
Income That Doesn’t Qualify
As we mentioned, only certain types of pension income are eligible for pension splitting. The pension income that’s not eligible for pension splitting is:
- OAS (Old Age Security) payments
- Canada Pension Plan payments
- Quebec Pension Plan payments
- Foreign pension income that is tax-free in Canada because of a tax treaty
- Income from a US IRA (Individual Retirement Account)
You also can’t claim any amounts from an RRIF that are included on line 11500 of your return that have been transferred to an RRSP, RRIF or annuity. Other than that, you can claim pension amounts for income splitting.
Examples of Income Splitting
When it comes to income splitting, it can be hard to understand how it can help you save money on your taxes. Let’s take a look at how income looks for one household member making all of the money versus having two separate incomes.
Let’s say you receive a pension, and the total amount of income you receive annually is $150,000. Based on the marginal tax rate, the total tax of $150,000 is $47,920 if you live in BC. Your marginal rate is 42.0%. If you split that so one person makes $100,000 and the other makes $50,000, then the tax breakdown is different.
If you claim just $100,000 for yourself as your annual income, then your tax amount reduces to $28,076. The tax amount on the $50,000 for your spouse is then $12.770. This means the total tax on the same amount is now $40,848. This is a total savings of $7,074 just by getting rid of the higher tax bracket. Your spouse still makes less money than you, but now you’re able to save some of that money on taxes.
Limits of Income Splitting
An important thing to remember when it comes to income splitting is that there are limits on how much you’re allowed to split with your spouse. The limits on these amounts are based on the kinds of income you’re splitting.
|Type of Income
|How Much You Can Split
|Up to 50% of contributions
|Based on the percentage of ownership
|Up to 50%
|Based on spouses' contribution to the business
|No specific thresholds
Splitting Employment Income
While you can’t split employment income in Canada, you can only split pension income; there are some circumstances in which you can split income while employed. These included the income-splitting strategies we talked about above, such as family trusts and loaning money to your spouse. You can also claim your spouse if you own your own business, but only if they actively contribute to the business. The amount you can claim for them is based on the amount that they contribute. This is the same for rental income. If you both own a property 50/50, then you can claim the rental income 50/50 on your taxes.
Is It Worth It?
Before you decide to split your income, it’s important to take a look at your tax planning strategy and decide if it’s worth it to split it or not. That said, if your spouse doesn’t have an income, or their income is significantly lower, and you’re able to split the income, then chances are you’ll save money by taking advantage of this option for your overall taxable income. For most who choose the splitting income strategy, it is worth it unless, for some reason, you have a lower tax bracket than your spouse. An example of this would be the disability tax credit.
Before you make any decisions, though, it’s important to keep in mind that this isn’t the only option available to save money on your taxes when you have a pension. There are a few other tax strategies, such as the pension tax credit.