The act of shifting money from a family member with a higher tax rate to a family member with a lower tax rate is known as income splitting. The objective is to lessen the total tax burden on families due to the progressive nature of the Canadian income tax system.
However, if you give a portion of your income to your spouse, they will still attribute it back to you, and you will be subject to a higher rate of taxation because of attribution regulations in the Income Tax Act that prohibit Canadians from income splitting. The Canada Revenue Agency (CRA) would be able to tax you significantly less if you and your spouse could divide your income and claim a portion of it on each other’s tax returns.
The attribution rules have certain unique exceptions, however, that let you employ income splitting to your advantage and increase family wealth.
Income Splitting methods
You may properly split your money using the four methods listed below.
- Spouse Loan
The Canada Revenue Agency sets the required rate, which is now 1%, every quarter. It first dipped to this historically low rate on July 1, 2020, after an increase to 2% in April 2018.
You should divide investment income with your spouse or another family member who makes less money to benefit from this low-advised rate.
It works in the following given manner:
- You make a financial loan to your spouse, whose income is taxed at a lower rate than yours.
- The money is being invested by your spouse.
- As a result, any dividends are subject to your spouse’s reduced tax rate.
You may give your spouse a loan of money provided that the following requirements are satisfied:
- The loan must accumulate interest.
- When the loan is approved, the interest rate must be in line with the CRA’s authorized rate.
- You will still be responsible for paying the interest if your spouse doesn’t do so before January 30 of the following year, and you may be subject to a higher tax rate.
Since the permitted rate is set for the duration of the loan, it will be a sensible strategy to reduce your taxable income if the expected return on your investment exceeds the granted interest rate. All returns are subject to your spouse’s lower tax rate. Your spouse is also entitled to a deduction for interest paid on loan.
- Splitting pension income
You may divide up to 50% of your qualified pension income with your spouse or common-law partner if you’re 65 years old or older. The T1032 Joint Election form to Split Pension Income must be submitted with your tax returns.
Pension income that may be shared includes:
- Lifelong annuity payments made under a registered pension plan
- Registered Retirement Savings Plan is referred to as RRSP (RRSP)
- Make delayed plans for profit sharing.
- A Registered Retirement Income Fund’s payments (RRIF)
The following are not included;
- Benefits under the Pension Plan of Canada
- Old age benefits
- Pension benefits
- Death benefits
- Transferring the excess funds from one RRIF to another, an RRSP, or an annuity.
- Particular profits shown on your T4RSP slips
- Amounts that were distributed as part of a retirement compensation program are shown on your T4A-RCA.
The amount of pension income that may be divided is further limited if you are under 65. Please go to the CRA’s website for further details (Eligible Pension and Annuity Income – less than 65 years of age)
If you and your spouse or partner have different tax rates in retirement, dividing your income might lower the total tax burden on your family. It makes no sense to divide your pension income if your tax rates are the same.
- Make RRSP contributions with your spouse
The spousal RRSP will help you balance your retirement savings if your spouse earns less than you do and is expected to have less income in retirement.
The steps are as follows:
- Your spouse would open a spousal RRSP in your name, separate from their RRSP account, to which you might make contributions.
- Upon conversion to an annuity or RRIF, your spouse will receive income and all RRSP profits are tax-free.
- Be careful not to make contribution more than the allowed limit to an RRSP. If the contribution maximum for your RRSP has been met, you cannot contribute to your spouse’s RRSP.
- Your spouse will pay tax on withdrawals at a reduced rate when they take money out in retirement.
- Funding all of your TFSAs
The most you may put into a Tax-Free Savings Account (TFSA) in 2021 is $6,000. You are thus allowed to make the maximum contribution to both your own and your spouse’s TFSAs since you are donating with money that has already been taxed.
Your spouse’s TFSA savings may be used for tax-free investments. Additionally, since you may take the money whenever you choose, it provides far more flexibility than an RRSP. Compound interest may significantly help the growth of your family’s wealth since it makes the money expand over time.
You may distribute profits to your spouse and children if your company is incorporated. Since both the dividends paid and the payout beneficiaries may change from year to year, this strategy gives a corporation a great degree of flexibility. The quantity of money you want to distribute to decrease your tax bracket will affect your option.