Income splitting strategies
Tax season is here and that leads many Canadians to consider opportunities to reduce their income tax bill now and in the future. One of the best ways to reduce personal income taxes is through income splitting: the ability to use the lower tax rates of other family members to decrease the personal tax bills of you and your family.
Changes to the rules around income splitting in recent years may have created confusion on the availability of these tax savings strategies. We have summarized some of the key strategies that continue to be effective in sharing the tax burden amongst family members below:
Registered Retirement Savings Plans (RRSP)
A higher income individual can make tax-deductible RRSP contributions for the benefit of the lower income spouse through a Spousal RRSP so that future withdrawals can be taxable at the spouse’s lower rate. Equalizing registered assets with your spouse or common law partner will allow you to utilize lower average tax rates in retirement through effective income splitting.
Tax-Free Savings Plans (TFSA)
Ordinarily gifts between spouses for investment purposes are subject to complex tax attribution rules; however, spouses can gift funds to each other for the purpose of TFSA contributions annually.
Registered Education Savings Plans (RESP)
Annual savings to RESPs for young children can help you take advantage of Canada Education Savings Grants (CESG) and tax deferral on the growth of your savings. In addition, when your child attends post-secondary school, the withdrawals from the RESP will be taxed in their hands, allowing for tax savings as a result of their lower tax brackets.
Note: If someone in your family is disabled, a Registered Disability Savings Plan (RDSP) can provide similar benefits.
An inter vivos trust could be created to hold investment assets for family member beneficiaries. Income from assets settled to the trust can be distributed to beneficiaries who may be in low tax brackets, effectively “sprinkling” income amongst multiple beneficiaries for tax savings for the family overall. This structure is popular where parents regularly fund their children’s education expenses and other lifestyle needs, even into adulthood. Keep in mind, this is a complex structure that will require legal and tax advice. There are costs involved in maintaining a trust on an annual basis that must be weighed against potential future benefits.
If you have large non-registered investment accounts, you can loan funds to your spouse so that more investment income is taxed in your spouse’s hands. This can be effective if your spouse is in a lower tax bracket than you. The loan must be carefully structured to ensure the transfer of funds can be tracked and the Canada Revenue Agency’s (CRA) prescribed interest rate at the time the loan is entered into must be charged to and paid by your spouse annually.
Pension income splitting
Current rules allow you to share certain types of qualified pension income with your spouse or common law partner for tax purposes. For example, income from a Defined Benefit Pension plan can be shared with a spouse at any age. For individuals age 65 or older, up to 50% of income from Registered Retirement Income Funds (RRIFs) can also be shared with their spouse for tax purposes. A Pension Tax Credit is available on the first $2,000 of qualified pension income providing additional tax savings.
Canada Pension Plan (CPP) and Québec Pension Plan (QPP) retirement benefits
Once you begin to receive your CPP or QPP retirement benefits, you can share up to 50% of the benefits with your spouse to reduce annual income taxes. CPP and QPP pension sharing is available under specific rules and require a formal application to Service Canada (for CPP) or Retraite Québec (for QPP). These programs are separate from pension income splitting, which is done through the tax returns.
Income Splitting for private corporations
Until recently, there were several more sophisticated strategies available to the shareholders of private corporations for “sprinkling” income amongst family members. As a result of sweeping changes to the rules around income splitting through private corporations last year, some of these approaches have been curtailed. Here are two strategies that can still be considered with the advice of your tax professionals:
Pay reasonable salaries to family members
Where you can show that your spouse and/or children have worked in the business, you may be able to pay them a reasonable salary. It is important to track their actual working hours, describe their work tasks, and define the terms of their employment. Wages must be reasonable based on the work performed and the age of the individual (i.e., school aged children).
Pay dividends to shareholders of private corporations over age 65
Despite the expanded “Tax on Split Income” (TOSI) rules for Canadian private corporations as of 2018, private corporations can continue to pay dividends to shareholders in specific situations. For example, in order to ensure consistency with other pension income splitting rules, where the business owner is age 65 or older and their spouse is a shareholder of the corporation, dividends can be paid to the spouse without attracting punitive TOSI tax consequences. If this exception did not exist, the dividend payments may be subject to the TOSI rules, which would tax the payment at the top marginal tax rate, regardless of the spouse’s tax bracket.
Income splitting continues to be a powerful planning approach to tax minimization, and there are many opportunities to benefit at different life stages. More sophisticated trust and loan arrangements are available that can benefit business owners and affluent families. If you are interested in learning more about income splitting strategies, please contact your Richardson Wealth Advisor to receive our detailed income splitting education article.