Last updated September 2, 2020.
What is income splitting?
Income splitting is the strategy of moving income from a family member in a higher tax bracket to a family member in a lower tax bracket. Since Canada has a graduated income tax system, the idea is to reduce the overall family tax burden.
But since the Income Tax Act has attribution rules that prevent Canadians from income splitting, if you gift your spouse part of your income, they’ll still attribute it back to you and you’ll be taxed at the higher rate. That’s because the Canada Revenue Agency (CRA) would collect substantially less tax from you if you could split your income with your spouse and declare part of it on their tax return.
However, there are exceptions to the attribution rules where you can use income splitting to your advantage and grow your family wealth. Below we outline four strategies you can use to make income splitting work for you.
1. Lend money to your spouse
The prescribed rate set quarterly by the Canada Revenue Agency has dropped from 2% to 1% as of July 1st. This is the first time its dropped since it was increased to 2% in April 2018.
Take advantage of this historically low prescribed rate by splitting investment income with your lower-income spouse or other family member.
Here's how it works:
- You lend money to your spouse, who is in a lower-income tax bracket than you.
- Your spouse invests the money.
- Any dividends are then taxed at your spouses' lower tax bracket.
You can loan money to your spouse as long as you follow these rules:
- It must be an interest-bearing loan
- The interest needs to match the prescribed rate set by the CRA at the time the loan is made
- Your spouse must pay the interest by January 30th of the following year, otherwise they'll still attribute it back to you and you'll be taxed at the higher rate.
The prescribed rate remains fixed for the term of the loan, so if your investment has expected returns higher than the prescribed interest rate, it will be a good way to help bring down your taxable income. Any return is taxed at your spouse’s lower rate. Plus, the loan interest expense can be deducted by your spouse.
Featured Resource: Tax Preparation Toolkit for Small Business Owners
2. Split pension income
If you’re 65 years or older, you can split up to 50% of eligible pension income with your spouse.
Eligible pension income includes:
- Lifetime annuity payments under a registered pension plan
- Registered retirement savings plan (RRSP)
- Deferred profit-sharing plan
- Payments from a registered retirement income fund (RRIF)
While you'll still receive the actual income, you can split it on your tax return to lower your tax payable.
3. Make contributions to a spousal RRSP
If your spouse is earning less money than you are, and there’s a good chance they’ll have less income in retirement, the spousal RRSP will help even out retirement savings for the both of you.
Your spouse would open a spousal RRSP account in their name (separate from their personal RRSP account), and you could contribute to the spousal RRSP.
Any income earned on the RRSP is tax-sheltered, and when the funds are turned into an annuity or RRIF, the payments are income to your spouse.
Just make sure you don't go over your RRSP contribution limit. If you max out your RRSP, you can’t contribute to your spouse’s RRSP.
4. Max out your TFSAs
In 2020, the TFSA contribution limit is $6,000. So you could max out your own contribution, and also max out your spouse’s TFSA - it’s tax-free so attribution doesn’t matter in this case. The funds in your spouse’s TFSA can be invested on a tax-free basis. And since you can take out the money at anytime, it has a lot more flexibility than an RRSP. Compounded interest will make the money grow over time, so it can have a significant impact on building your family wealth.
Free Guide: Tax Preparation Toolkit
We know you’re dreading it, but it’s got to be done – and with a little preparation, you can fulfill your tax obligations without any stress. Our simple, easy-to-understand toolkit will teach you how to get organized for tax season. Download your free tax preparation toolkit to learn what information and key documents you need to prepare so you’re ready for the tax filing deadline. There’s even a printable checklist that lists all the documents you’ll need as a business owner, and tax write offs you shouldn’t miss out on. Get the prep out of the way so you can get back to running your business. Download your toolkit today.
If you’d like to learn more about how FBC can support your business, call us at 1-800-265-1002 or email [email protected] Unlimited consultation related to tax matters is a key benefit of FBC Membership. You can also book an appointment online.