What is income splitting?
Income splitting is a tax-reduction strategy in which a taxpayer divides income or wealth with lower-income family members so that income is taxed at lower rates in those family members’ hands. The goal is to reduce overall family income tax. Attribution rules apply that often prevent you from simply giving cash or investments to family members, however.
Who can you split income with?
You may split income with your spouse (including a common law spouse), minor children or adult children. “Minor children” includes grandchildren, nieces and nephews under age 18.
Splitting income with your spouse
You may be able to split investment income, pension income, capital gains and business income. In some cases, income is split by transferring assets; other income can be divided at source. You can even trade your income-producing asset for an equal-value asset that does not earn income owned by a lower-income family member.
The simplest way to move some income to the lower-income spouse is to have the higher earner pay all household expenses. That way, any income earned by the lower-income spouse will be available for investing for taxation at their lower rate.
You can split income by lending money for investing to your spouse if their income is lower than yours. The investment income will be taxed in your spouse’s hands. The government’s prescribed interest rate for such loans is 2% (2019) – but the interest paid is tax deductible for your spouse because the money was borrowed to invest. Your spouse must pay you the prescribed interest rate each year and you will pay tax on it.
Even if you do not charge your spouse the prescribed interest rate and as a result pay tax on income earned by money given to your spouse, you will not pay tax on income earned by that income – that is, second-generation income. Your spouse can transfer interest earned to a separate account each year, and they pay tax on income earned in that account.
Note that interest earned within a TFSA is not subject to the attribution rules, so you may give or lend funds to your spouse to invest within their TFSA without tax consequences to you.
If you operate a business, you can pay reasonable salaries to your spouse and/or children for work they do in the business. As well, you can perform an estate freeze and then issue dividend-earning shares to your adult children.
If one spouse receives an employer pension, you can elect to have half of it transferred to the other spouse each year on your tax returns. If you are over 65, you can also split Deferred Profit Sharing Plans, and payments from RRIFs, LIFs and annuities purchased with RRSPs.
If you and your spouse are both over 60, you may be able to pool and share your CPP pensions. With this strategy, each spouse receives half of the couple’s total CPP benefits.
Another way to split income with your spouse is through a spousal RRSP, if your income is likely to be different from theirs in retirement. The higher-income spouse uses their contribution room to contribute to their spouse’s RRSP and gets the tax deduction now, but the lower-income spouse pays the tax when the funds are withdrawn in retirement. (Funds must stay in the spousal RRSP for three years before they are taxed to the lower-income spouse.)
Splitting income with children
Giving assets to a minor child, or lending at a low rate, will trigger attribution rules for interest or dividend income. But capital gains will be taxed in the child’s hands, so consider setting up an in-trust capital growth account in the child’s name.
Contributing to a Registered Education Savings Plan can split investment income with your children. You contribute to the plan, but when your children withdraw funds for education, they pay tax on interest earned within the plan (including interest on Canada Education Savings Grants) at their likely lower tax rate.
Similarly, if you contribute to a Registered Disability Savings Plan for a family member, income earned within the plan is taxed in that person’s hands.
You can usually give or lend assets to an adult child without any resulting investment income triggering the attribution rules – unless the Canada Revenue Agency deems that the gift or loan was made specifically to avoid tax.
Keep attribution rules in mind
Talk to your accountant before planning to use any of these income splitting strategies and others not mentioned here. Many rules apply and they change often. As well, transferring assets can have other tax consequences, so take advantage of expert advice to make sure you are using the strategies effectively.