Income Splitting Strategies

Saving tax is a topic that almost everyone is interested in. Despite rules in the Income Tax Act to limit ways to save tax, there are still some ways to accomplish tax savings through income splitting with your family members.

This article will examine some of the methods available with your spouse. The next article in this series will focus on income splitting opportunities with children.

Why Income Split?

The purpose behind income splitting is simple. It is designed to shift income from an individual in a high tax bracket to an individual in a lower tax bracket. The result is tax dollars saved and therefore more family income and more capital in the hands of the lower income individual.

Income Splitting With a Spouse

For many people, income splitting with a spouse is very attractive as many couples find themselves in different tax brackets for most of their lifetimes. Although there are attribution rules contained in the Income Tax Act that limits income splitting with your spouse, there remain some legal methods.

1. Spousal RSP

The most obvious income splitting strategy between spouses is the spousal RSP. Although there are no immediate tax savings as you still receive the deduction, there are tax savings in the future when your spouse receives income from the RSP. This income will be taxed at their marginal tax rate instead of yours. The attribution rules will cause income to be taxed in your hands however if your spouse withdraws money from the spousal RSP and you have made a contribution in that year or the previous two years to any spousal plan.
2. Spousal Loans

Because of our current low interest rate environment now is an especially good time to consider a spousal loan. From January 1, 2008 through March 31, 2008, Canada Revenue Agency’s (CRA) prescribed rate of interest for family loans is only 4%. Therefore, where assets are expected to produce a return that is well in excess of this rate, it makes sense to loan assets to your spouse and charge the 4% rate of interest to avoid the application of the attribution rules. The excess yield from the assets over the amount of interest charged will then effectively be transferred to the lower-income spouse without triggering the attribution rules.

How does this strategy work?

The higher income-earning spouse lends a sum of money to the lower-income spouse. Under a written loan agreement, the lower-income spouse agrees to pay interest at the prescribed rate of 4%. The lower-income spouse then invests the borrowed funds at a rate greater than 4% to make this strategy as tax effective as possible.

For example, Bob lends Sandra (the lower-income spouse) $100,000 by way of a promissory note and charges her interest of 4%. Sandra then invests this money and earns a 5% rate of return. Sandra reports $5,000 of investment income on her tax return ($100,000 * 5% rate of return) and gets a tax deduction for the $4,000 of interest she pays to Bob. ($100,000 * 4% prescribed interest rate). Bob reports on his tax return $4,000 of interest income. As a result of this $100,000 loan, $1,000 of annual income has been shifted from Bob to Sandra.

For this strategy to work Sandra must pay Bob the interest (this is tax deductible to Sandra as an interest expense) by the following January 30th of each year and Bob must report the interest received as income. This couple has effectively split income and therefore saved some tax.

One of the best advantages of this process is that you are locking in this low rate of 4% indefinitely even if the prescribed interest rate rises.

3. Pension Income Splitting

Individuals who earn income eligible for the pension income tax credit may reduce their overall household tax bill through the pension income splitting measure introduced by the federal government in October 2006. This initiative allows the higher income earning spouse to allocate up to 50% of their eligible pension income to their lower income earning spouse, where it will be taxed at their lower marginal rate. The types of pension income eligible for income splitting will vary depending on age:

• For people age 65 and older, eligible pension income includes lifetime annuity payments under a registered pension plan (RPP), a registered retirement savings plan (RRSP) or a deferred profit sharing plan (DPSP), and payments from a registered retirement income fund (RRIF).
• For individuals younger than 65, eligible pension income includes only lifetime annuity payments from an RPP (employer-sponsored pension) and certain other payments received upon the death of a spouse or common –law partner.

4. Split Your CPP Payments

When you apply to start receiving your CPP payments, you can elect to split them with your spouse. As long as you are in a higher tax bracket this strategy makes sense as the amount of tax paid by the family will be deceased.

5. Invest Your Spouse’s Excess Income

If both you and your spouse work, and there is excess income that is being invested, this income should be invested in the hands of the individual in the lower tax bracket. Therefore, the spouse with the higher income should pay all the house hold expenses, with the lower income spouse saving the excess funds in their hands. Future income on the invested funds will be taxed at a lower rate. Note that you only need to continue this strategy until both spouses are in the same tax bracket.

6. Pay Your Spouse a Salary

If you own your own business, you can pay your spouse a salary for work that they perform. Remember however that it must be reasonable in the circumstances and that usually means that you would pay your spouse the same as what you would pay someone else for work of equal value.

7. Loans to a Spouse to Start a Business
Business income is not attributable so it is possible to loan your spouse money to start their own business. Any income that they earn in the business will be taxable in their hands.
Note: The above article is for information purposes only and should not be construed as offering tax advice. Individuals should consult with their personal tax advisors before taking any action based upon the information in this article.

Tax Planning Year Round

You and your taxes: Establishing a year round process.

Does most of your tax planning take place during the last few months of the year? If so, you are not alone. However, to effectively reduce your current and future tax liabilities, tax planning should be a year round endeavor. Here are some opportunities.

Split your income

Income splitting involves structuring your affairs to move income into the hands of a lower-income family member who will pay less tax.

A spousal RRSP allows a higher-income spouse to contribute to the RRSP of a lower-income spouse. At retirement, this can help shift more income to the spouse who is expected to be in a lower tax bracket.

Another possibility is a spousal loan. As long as a prescribed rate of interest is paid, a spousal loan can be an effective way to transfer assets from a spouse in a higher tax bracket to a spouse in a lower tax bracket.

Donate securities

If you are considering a charitable donation, you may want to give stocks, bonds, or other publicly traded securities, including mutual funds. You’ll be deemed to have sold the investments at fair market value, however, any capital gains will be eligible for a reduced capital gains inclusion rate of 25% instead of 50%.

Create deductible debt

Tax deductible loan interest can be a great tax-saver. One strategy is to convert all or part of your mortgage debt into an investment or business loan.

For example, you could sell some investments to pay off your mortgage, then take a loan to repurchase the investments. This will effectively replace your non-deductible mortgage debt with a deductible investment loan.

Maximize your RRSP

Your RRSP is one of the few good tax shelters left. But don’t wait for the deadline to make your contribution. The sooner you invest, the longer your savings will be able to grow on a tax deferred basis. A monthly RRSP contribution plan can make this easy. And, if you have significant unused RRSP contribution room, a short-term loan is often a great way to catch up.

Consider an RESP

Today, a four-year university education in Canada costs $32,000 or more. In 18 years, using a 5% annual inflation factor, that number could rise to $77,000. Although contributions to a Registered Education Savings Plan (RESP) are not tax deductible, the income earned in the plan grows tax-free until it is withdrawn by the student. Plus, you could receive up to $500 a year in government grants to help your savings along. Consider this option if you have children with ambitions for higher education.

Make the right decisions all year
- Tax planning means that you are entitled to arrange your affairs, within the limits of law, so that you pay a minimum amount of tax.

Contact us at (604) 535-4749, or use our contact page.