“To get the full value of joy you must have someone to divide it with,” according to master of the pen Mark Twain. Twain, despite being a doyen of the written word, lost a substantial amount of money through bad investments and eventually filed for bankruptcy. It’s unlikely, therefore, that he was savvy enough to implement an income splitting strategy to lessen his tax burden. In his defence, he was clearly more adept at matters of the heart - his marriage lasted 34 years.
Still, his belief in the strength of sharing joy can be related to the more prosaic, modern-day task of income tax returns. For those of you still shaking off the hassle of this year’s returns, the planning for next year should start now. And one way to stay a step ahead and improve next year’s returns is income splitting. There are different ways to maximize this strategy but essentially, it is a way of utilizing the income tax brackets to reduce the family’s overall gross tax level by having a high-income family member transfer a portion of their income to a lower-income family member. The family still earns the same amount but the amount of tax due is reduced.
This strategy was, of course, not available to Twain in the US in the 19th century – he did alright for himself regardless – but for Canadian families who want their money to work harder in 2024 and beyond, here are four ways to implement the strategy.
Attribution rules
First, however, there is a fundamental CRA rule to understand because it’s not as simple as having the higher-income earner gift investments or investment money to the lower-income earner. CRA requires individuals to declare income sources, meaning any income generated from these gifts would be attributed back to the higher earner and taxed at their higher rate.
There are, however, exceptions to this rule.
1. Splitting pension income
This is the easiest method for those 65 years or over, and most effective if one spouse’s income is significantly more than the other and, therefore, in a different tax bracket. If both partners have eligible income, the higher earner can split up to 50% with their spouse or common-law partner.
The pension income eligible includes: lifetime annuity payments under a registered pension plan; registered retirement savings plans; deferred profit-sharing plan; and payments from a Registered Retirement Income Fund (RRIF). Importantly, you can not split the following income: Old Age Security benefits; Canada Pension Plan benefits; death benefits; retiring allowances; excess amounts from an RRIF transferred to an RRSP, another RRIF or annuity; and specific income as reported on your T4RSP slips. Split pension income can also be eligible for a pension income tax credit at both the federal and provincial levels
Be mindful, however, as the transferee’s OAS clawback may be increased by the transfer because their net income will increase.
Prescribed rate loan
An area where the attribution rules do not apply is loans to a spouse, common-law partner or adult child, which the CRA allows, so long as the minimum interest paid meets the CRA-prescribed interest rate. For the first quarter of 2024, this was set at 6%, the highest since 2001.
A loan from a family’s higher earner is invested by the lower earner to gererate income and the amount earned above the prescribed rate is taxed at the hands of the lower-income family member. The lower the prescribed rate, the more effective this strategy can be in boosting your tax savings. Importantly, the borrower must be able to pay the interest to the high earner by January 30 of the following year to avoid the attribution rules.
The two most common strategies are spousal loans and using a family trust. The latter involves the same principles and is typically set up by parents or grandparents for the benefit of their children, grandchildren, nieces or nephews. Instead of loaning the money to a spouse, you loan the money to a trust at the prescribed rate. If the low-income family member is a child, they pay little or no tax. Often this is used as a tax-efficient way to pay for tuition or camp fees.
It's important the trust is set up correctly as it will incur administration costs. Make sure you consult your Q Wealth Portfolio Manager for more details.
Spousal RRSP
If you or your spouse are earning less than the other while working, the lower earner will likely have a lower income in retirement. There is, however, a pre-retirement strategy that redistributes your savings more evenly and helps you pay less tax as a couple overall. Unlike the family trust, it requires very little additional support to set up a spousal RRSP.
Once set up, the higher-income spouse, who has a bigger contribution limit, puts money into an RRSP under the lower-income spouse’s name. This is separate from their personal RRSP account. This means the higher earner gives up some contribution room, but they still get to claim the tax deduction. Fast forward to retirement and the lower-income earner converts the RRSP to a RRIF (in retirement, of course) and they pay less tax because they’re in a lower marginal rate.
Max out TFSAs
While not a strategy to ease the tax burden now, this is a very simple, forward-looking strategy that can provide your family with more tax-free income in the future. While the contributions are after-tax dollars, any investment growth inside a TFSA is tax-free when withdrawn. By maxing out your spouse’s TFSA, as well as your own, this is an effective way to grow your family’s wealth.
A 1902 quote attributed to Twain goes, “What is the difference between a taxidermist and a tax collector? The taxidermist takes only your skin.” Most of us have felt this pain at times. The above strategies, however, can help you and your spouse ease your tax burden and redirect extra funds to other areas of your life. One suspects Twain would approve.
