Last updated: Jan. 5, 2022
What is income splitting?
Income splitting is the strategy of moving income from a family member in a higher tax bracket to a family member in a lower tax bracket. Since Canada has a graduated income tax system, the idea is to reduce the overall family tax burden.
But since the Income Tax Act has attribution rules that prevent Canadians from income splitting, if you gift your spouse part of your income, they’ll still attribute it back to you and you’ll be taxed at the higher rate. That’s because the Canada Revenue Agency (CRA) would collect substantially less tax from you if you could split your income with your spouse and declare part of it on their tax return.
However, there are exceptions to the attribution rules where you can use income splitting to your advantage and grow your family wealth. Below we outline four strategies you can use to make income splitting work for you
1. Lend money to your spouse
The prescribed rate set quarterly by the Canada Revenue Agency is currently sitting at 1%. It dropped to this historically low rate on July 1st, 2020, which was the first time it dropped since it was increased to 2% in April 2018.
Take advantage of this low prescribed rate by splitting investment income with your lower-income spouse or other family member.
Here’s how it works:
- You lend money to your spouse, who is in a lower-income tax bracket than you.
- Your spouse invests the money.
- Any dividends are then taxed at your spouses’ lower tax bracket.
You can loan money to your spouse as long as you follow these rules:
- It must be an interest-bearing loan
- The interest needs to match the prescribed rate set by the CRA at the time the loan is made
- Your spouse must pay the interest by January 30th of the following year, otherwise they’ll still attribute it back to you and you’ll be taxed at the higher rate.
The prescribed rate remains fixed for the term of the loan, so if your investment has expected returns higher than the prescribed interest rate, it will be a good way to help bring down your taxable income. Any return is taxed at your spouse’s lower rate. Plus, the loan interest expense can be deducted by your spouse.
2. Split pension income
If you’re 65 years or older, you can split up to 50% of eligible pension income with your spouse or common-law partner. You must fill out the Joint Election to Split Pension Income form when you’re filing your personal tax returns.
Pension income eligible for splitting includes:
- Lifetime annuity payments under a registered pension plan
- Registered Retirement Savings Plan (RRSP)
- Deferred profit-sharing plan
- Payments from a Registered Retirement Income Fund (RRIF)
It does not include:
- Old Age Security benefits
- Canada Pension Plan benefits
- Death benefits
- Retiring allowances
- Excess amounts from an RRIF transferred to an RRSP, another RRIF or annuity
- Specific income as reported on your T4RSP slips
- Amounts distributed from a retirement compensation arrangement on your T4A-RCA slip
If you are under the age of 65, the pension income you are eligible to split is further limited. Visit the CRA’s site for more information (Eligible Pension and Annuity Income – less than 65 years of age)
If you and your spouse are in different tax brackets at retirement, income-splitting could lower the overall tax bill for your family. If you are in the same tax bracket, there would be no benefit to splitting your pension income.
NOTE: The Pension Income Tax Credit of $2,000 is one that is available to every Canadian retiree. Splitting your pension income with a spouse who is not currently receiving a pension would allow them to also claim the tax credit.
Each province (excluding Quebec) also has a pension income tax credit that can provide additional tax savings on eligible pension income.
There are rules in place to claim the credits and we recommend speaking with a tax professional to ensure you are eligible.
3. Make contributions to a spousal RRSP
If your spouse is earning less money than you are, and there’s a good chance they’ll have less income in retirement, the spousal RRSP will help even out retirement savings for the both of you.
Here’s how it works:
- Your spouse would open a spousal RRSP account in their name (separate from their personal RRSP account), and you could contribute to the spousal RRSP.
- Any income earned on the RRSP is tax-sheltered, and when the funds are turned into an annuity or RRIF, the payments are income to your spouse.
- Just make sure you don’t go over your RRSP contribution limit. If you max out your RRSP, you can’t contribute to your spouse’s RRSP.
- When your spouse withdraws the money in retirement, they’ll pay tax on the withdrawals at the lower rate.
4. Max out your TFSAs
In 2021, the Tax Free Savings Account (TFSA) contribution limit is $6,000. So you could max out your own contribution, and also max out your spouse’s TFSA – attribution doesn’t matter in this case as you are contributing with funds that have already been taxed.
The funds in your spouse’s TFSA can be invested on a tax-free basis. And since you can take out the money at anytime, it has a lot more flexibility than an RRSP. Compounded interest will make the money grow over time, so it can have a significant impact on building your family wealth.
[Bonus Tip] Pay dividends to your spouse and children
If your business is incorporated, you can pay dividends to your spouse and children. This strategy offers great flexibility to an incorporated business since the dividends paid can vary from year to year, as can the recipients receiving them. This decision will be based on how much income you want to distribute to lower your tax bracket.
You must first set up your incorporated business to include your spouse and/or children as shareholders. Note, this doesn’t have to be done at inception of the corporation as you can amend shareholders throughout the year – remember to update your minute book to reflect the changes. You are then permitted to distribute dividends between family members to reduce your tax burden.
Note: shareholders do not have to employees to receive dividends. But employees can be shareholders and receive both a salary and dividends through the business.
A word of caution: there are limitations and anti-tax-avoidance rules put in place by the CRA regarding issuing dividends to family members who have not invested or worked in the business.
There are additional income splitting strategies available to Canadian taxpayers, but you should consult with a tax professional well in advance of your year-end to ensure it’s right for your situation.
Free Guide: Tax Preparation Toolkit for Small Business Owners
We know you’re dreading it, but it’s got to be done – and with a little preparation, you can fulfill your tax obligations without any stress. Our comprehensive tax preparation toolkit will help you get organized for tax time.
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