Last updated: Jun. 8, 2023
Income splitting redistributes income within a family—typically from a higher-earning spouse in a higher tax bracket to a spouse in a lower tax bracket. This strategy may help reduce a family’s overall tax burden, by helping the higher-earning partner reduce their tax bill.
Income splitting takes advantage of Canada’s progressive tax system, which imposes higher tax rates on those who earn higher incomes. By allocating income to lower-income family members, a taxpayer can effectively reduce their overall taxable income, which may lead to a lower tax bill.
This can be a beneficial strategy for Canadian farmers. Because the average age of this demographic is around 56 years old, income splitting may result in a lower tax bill for married couples, allowing them to use the lower-earning spouse’s salary and other income for investment purposes. This results in the family’s total investment income being taxed at the lowest possible rate.
Who is eligible for income splitting?
Now that we know what income splitting is, who is eligible? In general, income splitting works best when one spouse earns a significantly higher income than the other, so the tax savings are more significant. It’s also a helpful tax strategy for pensioners, allowing anyone 65 or older to divide 50 percent of their eligible pension income with their common-law partner or spouse.
How does income splitting work?
Income splitting works by allowing one spouse to transfer income to their partner, to optimize the various tax credits and deductions. This decreases the overall tax burden on the family since it places more taxable income in the lower earners’ hands.
While it may sound like a simple process, there are attribution regulations mandated by the Canadian Revenue Agency (CRA) that require individuals to report their income sources, including any money earned from investments using their savings or capital. This means that all income generated from a gifted investment must be attributed back to the high earner. This money is then taxed at the rate paid by the original spouse (who is typically in a higher tax bracket).
However, there are a few exceptions to these rules. Let’s take a closer look at some popular income splitting strategies and how they can benefit Canadian farmers:
1. Contributions Made to a Spouse’s Registered Retirement Savings Plan
A spousal registered retirement savings plan (RRSP) can reduce the tax burden both now and during retirement.
Using this method, the higher-income spouse with the larger contribution limit deposits money into an RRSP in the lower-income spouse’s name. Using this strategy, the high earner uses some of their contribution room during that tax year. However, this allows them to claim the tax deduction.
The money held in the spousal RRSP must remain in the account for a minimum of three years, before it may be withdrawn by the spouse. After the three years have passed, the spouse may withdraw the funds from their RRSP account and report the income on their tax return, ultimately paying less tax on the money. Careful attention must be paid to ensure the appropriate time has passed, or the withdrawal will be reported on the original spouse’s income tax return, likely resulting in a higher tax bill.
As well, when the lower-income spouse is ready to retire, they can convert the RRSP to a registered retirement income fund. This allows them to pay fewer taxes due to the marginal tax rate. If one spouse currently earns less money, they’re likely to have less income when they retire. The spousal RRSP can redistribute retirement savings to be more equitable while helping you pay less tax overall.
An RRSP is simple to set up, offers immediate tax advantages, and provides long-term stability for the spouse earning a lower income.
2. Spousal TFSAs
Although tax-free savings accounts (TFSAs) don’t lower or eliminate your current tax burden, they can provide Canadian farmers with future income that’s virtually tax-free.
Any interest earned from money deposited into the TFSA is protected from taxation, allowing you and your spouse to maximize your contributions, even when it’s time to withdraw the funds. And unlike a spousal RRSP, the money can be taken out at any time.
A TFSA can hold different types of investments, such as a high-interest savings account, mutual funds, bonds, and stocks. Whatever type of investment you prefer, it allows you to earn tax-free income and increase your family’s wealth over a period of time. The TFSA contribution limit is currently $6,500 per person.
3. Split Pension Income
Canadians who are 65 and older can split up to half of their eligible pension income with their common-law partner or spouse. If the incomes of both spouses are eligible, you’ll have to identify who will receive the money. Typically, the money will be transferred from the higher-income spouse to the lower earner. Then, you’ll be required to complete the CRA’s form T1032 Joint Election to Split Pension Income form with your annual tax return.
Remember that pension-sharing income doesn’t include:
- Canada Pension Plan benefits
- Old Age Security benefits
- Retiring allowances
- Specific income reported on your T4RSP slips
- Certain foreign pension income (including income from a United States individual retirement account – or an “IRA”)
This gives Canadian farmers a lower taxable income, especially if you and your spouse fall into different tax brackets once you retire.
Can income splitting benefit you?
Now that you know what income splitting is, learn how it can reduce your tax burden. We’ve been helping Canadian farmers and agricultural producers minimize their income taxes and maximize their assets for 70 years. We offer tax planning, preparation and audit representation, bookkeeping, payroll, and financial planning to cover your complete financial needs.
Book your free consultation now.
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Engaging in tax planning now allows you to get organized and assess what cost-saving actions you can take before tax year-end to lower your future business or corporate taxes next spring.
Consider this toolkit your roadmap to help you get organized, reduce your tax burden, and keep more money in your pocket. In here you’ll find some of the most successful year-end tax planning strategies we employ for our tax Members who farm or own agribusinesses.
