Income splitting is a tax strategy to reduce family taxes by shifting income from high income earners to low income earners and takes advantage of the different tax brackets that exist in Canada. Canadian tax rules require that each individual file their own tax return and report their own income. This differs from the US tax system where couples can combine their income and jointly file a tax return.
By splitting income, the high income earner can reduce their net income and taxable income. This has the following benefits:
- reducing the taxpayer's marginal tax rate (and possibly increasing the spouse's marginal rate)
- reducing or eliminating Old Age Security clawback
- creating a pension tax credit for the spouse (with pension splitting)
The Income Tax Act (ITA) contains a set of attribution rules that prevent family members from transferring assets between themselves for the purpose of avoiding taxation. Most of the attribution rules are located in sections 74.1 to 75 of the ITA. IT511R - Interspousal and Certain Other Transfers and Loans of Property discusses a comprehensive set of rules intended to prevent a taxpayer and the taxpayer's spouse from splitting income from property so as to reduce the total amount of tax payable on that income.
Canadian residents may split up to 50% of eligible pension income with their resident spouse or common-law partner as of the 2007 tax year. You (the pensioner) and your spouse or common-law partner (the pension transferee) must make a joint election on Form T1032, Joint Election to Split Pension Income. This form must be completed, signed and attached to both your and your spouse's or common-law partner's paper returns by your respective filing due date. The information on the forms must be the same.
No actual funds are transferred when splitting pension income, it is bookkeeping entries on your respective tax returns. Only one joint election can be made for a tax year.
You may want to set up a spousal or common-law partner Registered Retirement Savings Plan (RRSP). This type of plan can help ensure that retirement income is more evenly split between both of you. The benefit is greatest if a higher-income spouse or common-law partner contributes to an RRSP for a lower-income spouse or common-law partner. The contributor receives the short term benefit of the tax deduction for the contributions, while the annuitant, who is likely to be in a lower tax bracket during retirement, receives the income and reports it on his or her tax return. There is a three-year restriction on the owner of a spousal RRSP making a withdrawal. This is based on calendar years, not the three years from the last contribution.
Tax-Free Savings Accounts
Unlike the rules for Spousal RRSPs, you can provide money for a spouse’s Tax-Free Savings Account (TFSA), and still have the growth in value of that TFSA belong to the spouse. When this is done there is no income to be attributed.
Spousal loans are loans between family members at the Canada Revenue Agency's prescribed rate. The interest rate charged can be fixed for the duration of the loan, which offers a tax planning opportunity when interest rates are low. The loan must be properly documented with a promissory note or loan agreement and actual funds must be shown to have been exchanged when the loan is created and when interest payments are due.
- TaxTips.ca - Income splitting, viewed August 21, 2012.
- Canada Revenue Agency, Eligible pension income, viewed August 21, 2012.
- Canada Revenue Agency, How do you split your pension income?, viewed August 21, 2012.
- Canada Revenue Agency, Setting up an RRSP, viewed August 21, 2012.
- Canada Revenue Agency, Withdrawing from spousal or common-law partner RRSPs, viewed August 21, 2012.
- Tax Facts & Planning - The Tax-Free Savings Account (TFSA) | TMXmoney, viewed August 21, 2012.
- Canada Revenue Agency, Prescribed interest rates, viewed August 21, 2012.