What is income tax splitting? And how can it reduce your tax?

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There are several tax benefits to being part of either a married or common-law couple. These include taking advantage of the spousal tax credit and pooling your charitable donations and medical expenses to receive a larger tax credit.

Another key advantage of having a domestic partner is income tax splitting. Its goal is to spread the income of the higher-earning spouse to the lower-earning spouse, to reduce the couple’s overall tax obligations (though if both spouses earn roughly the same income, it’s not worthwhile). 

For working couples, there are several strategies that can help you to indirectly split your income to lower your taxes (directly shifting working income from one spouse to the other is not allowed in Canada). For retired couples, retirement income splitting is allowed for certain sources of income.

Let’s take a look at ways you could shift income around to lower your overall tax burden. 

Income splitting through spousal RRSP contributions

With this particular type of RRSP, Canadian spousal income splitting rules allow for the higher-earning spouse to contribute to their lower-earning spouse’s RRSP. There are both immediate and long-term benefits to this strategy:

  • The RRSP contribution limit is based on that of the higher-earning spouse, so this allows for a larger amount of retirement savings than otherwise.
  • The higher-income spouse receives a tax deduction every year they contribute.
  • When the money is withdrawn, it is at the lower-income spouse’s tax rate, making for significant tax savings.
  • The higher-earning spouse can continue to contribute to a spousal RRSP and reduce their taxable income, even after they turn 71, if their spouse is younger.

The money has to stay in the account for at least two calendar years after the contribution is made, otherwise there are tax implications for the higher-earning spouse. You can find out more details at the Government of Canada’s RRSP webpage

Saving on income tax with a spousal loan

If you give an investment asset to your spouse, you can expect the income generated from that asset to be attributed back to you. However, Canada Revenue does allow for spousal income splitting by letting you lend your spouse money, which they can then use to put into investments.

The lending spouse does have to charge a nominal rate of interest (3% as of October 2022 — the latest prescribed rates are on the CRA website), which means that, for tax purposes, the interest amount is counted as income for the lending spouse. 

The borrowing spouse can then use the money to invest (and would hopefully get returns higher than 3%), which would increase their overall investment income, at the lower tax rate. The borrowing spouse may also be able to deduct the interest paid from their earnings.

Max out your TFSAs

Tax-free savings accounts have more flexible rules when it comes to indirect income tax splitting. The lower-income spouse can use money from a joint account to invest in their TFSA.

This allows both spouses to maximize the tax-free growth that TFSAs provide, without any negative tax implications.  

Income tax splitting for retirees

Splitting retirement income can be extremely tax-efficient, especially if one spouse has significantly more retirement income than the other.

It involves the higher-earning spouse sharing their retirement income with the lower-earning spouse, for tax purposes. This strategy typically brings about an overall reduction in tax owed by the couple, given that it brings the high-earning spouse into a lower tax bracket. If both spouses have similar retirement incomes, there would be no advantage.

Here’s how it works:

  • To be eligible for retirement income tax splitting, both spouses must be living together, in Canada (though there are some exceptions).
  • Eligible income includes a company pension plan, registered retirement income funds (RRIFs), registered retirement savings plans (RRSPs) and life annuities.
  • Income from the Canada Pension Plan, Quebec Pension Plan and Old Age Security are not eligible for Canadian income splitting.
  • You can transfer as much as 50% of your eligible retirement income to your spouse.
  • This could bring the higher earner down to a much lower tax bracket.
  • Some age restrictions apply.
  • Pension income splitting can allow for the use of the pension income amount (a tax credit of $2,000) for both spouses. 

Both spouses need to complete and sign Form T1032 Joint Election to Split Pension Income to apply for Canadian retirement income splitting. The forms should contain identical information and then be attached to both spouse’s tax returns. 

How to get started with income tax splitting options

As with any issues related to tax, you should talk to your accountant or tax specialist to discuss the most tax-efficient strategies for your particular situation.

Your IG advisor can also give you advice on how income tax splitting strategies can benefit your overall financial plan. Call your IG advisor today to book a meeting: if you don’t have an IG advisor, you can find one here.

 

 

Written and published by IG Wealth Management as a general source of information only. Not intended as a solicitation to buy or sell specific investments, or to provide tax, legal or investment advice. Seek advice on your specific circumstances from an IG Wealth Management Consultant.