The biggest myth that wealth adviser Rob Tetrault hears about income splitting is that it’s no longer available to families in Canada.
“I definitely hear that — that there’s nothing you can do anymore with respect to income splitting because the government’s taken away all of the methods people used to employ back in the day,” says Mr. Tetrault, a portfolio manager with Tetrault Wealth Advisory Group at Canaccord Genuity in Winnipeg.
The federal government has indeed done away with the most contentious income-splitting mechanisms that allowed owners of private corporations to lower their tax burden by paying dividends to family members. In 2018, the tax on split income (TOSI) rules were implemented, applying the top marginal tax rate to dividends paid to family members who could not demonstrate substantial, regular engagement in a business. (Revenue Canada defines meaningful engagement as working at least 20 hours a week in the business, in at least five prior years.)
Still, there are plenty of ways for families, including many middle- and lower-income households, to redistribute assets and earnings between higher-and lower-income earners to drive down the family’s overall tax bill. Importantly, advisers say it’s about playing the long game, looking not only at tax efficiency today but optimizing investments and retirement savings for the future.
One of the simplest strategies is a spousal registered retirement saving plan (RRSP). If one spouse earns a substantially higher income, they can use some of their own RRSP contribution room to top up a lower-earning spouse’s RRSP. The higher-earning spouse will be able to claim the tax deduction as they would to their own RRSP, which is a bigger bang, savings-wise, given their higher tax bracket.
“The RRSP will reduce your net income for tax purposes,” says Evelyn Jacks, a personal finance author and president of the Canadian financial-education institute Knowledge Bureau. “You’ll also possibly get more credits like child tax benefit,” she says, which are geared to income. And a savvy couple can reinvest those refunds.
“You can leverage those tax savings, and a TFSA [tax-free savings account] is a great thing to leverage that into,” Ms. Jacks says. “Each one of you can contribute to your lifetime maximum then and fund a tax-free retirement.”
Another common approach is a spousal loan, which is usually beneficial for situations in which one spouse has significantly more taxable income than the other. With this arrangement, the higher-earning family member can loan money to a lower-earning spouse at the Canada Revenue Agency’s prescribed rate (currently 1 per cent). The strategy is to invest the loaned money with a goal of earning a higher return than the prescribed rate, while at the same time having the family unit save tax.
“As long as interest is being charged at the prescribed rate, and the interest is paid within 30 days from the end of the year, the resulting earnings can be reported by the lower earner,” says Lea Koiv, a Toronto-based tax and estate expert.
And since interest paid for loans used to earn investment income is tax-deductible, there’s an additional advantage, Ms. Koiv adds.
What’s more, the prescribed rate at the time the loan is made lasts for its lifetime, regardless of what happens to interest rates long-term. With interest rates as low as they are right now, this is a particularly attractive option, Ms. Koiv says.
A similar but more complex arrangement better suited to families handling more wealth could be a family trust.
The TOSI rules eliminated some of the flexibility of using family trusts, but there are still several effective techniques, particularly the prescribed-rate loan strategy, which functions much like a spousal loan, Mr. Tetrault says.
Funds are loaned to the trust by the high-income earner (or a family business) at the prescribed rate and the trust invests them. The yields can be reinvested, growing inside the trust. When low-income family members are paid out, the earnings are taxed at each beneficiary’s marginal rate.
“Maybe you’re helping kids or grandkids with education expenses,” Mr. Tetrault says. “If they’re students, their income may be nothing, or almost nothing, and the trust income will be effective taxed at zero.”
Pension income splitting
Pension income splitting is another option often used by older Canadians. With this strategy, higher-income spouses can transfer up to 50 per cent of eligible pension income to a lower-income spouse to reduce their overall household tax burden.
Eligible income sources include registered retirement income funds (RRIFs) and company pension plans, as well as certain annuities. In most cases, the pension recipient must be 65 or older, but the spouse receiving the split income can be any age. Old age security and CPP are generally not eligible, though some people may qualify to split CPP. This requires a special application to Service Canada, and is subject to certain rules, including co-habitation stipulations.
Mr. Tetrault encourages couples to consider pension income splitting long before they reach retirement age.
“What I always like to say is ‘try to picture your life at retirement: Your cash flow, your cash needs, and your drawdown strategy for all the assets you have, as well as which assets each household member will have,’” he says. “I know this could be tough for a 35-year-old couple, but if you could try to picture what the retirement income flows look like, then you could start making a game plan for current strategies to income split at retirement.”
Not just for the wealthy
The goal of income splitting is simple, says Ms. Jacks: You average down your household’s income to pay less tax earlier in life, which gives you a chance to reinvest those savings in either tax-sheltered or tax-efficient investments.
Still, income splitting is far from simple and she recommends working with a tax specialist or other expert in the field to make sure you’re doing it right, regardless of your income bracket.
“It’s really a fallacy that this is only for very wealthy people, or not something to think about when income is low,” Ms. Jacks says. “Because of the effect of income splitting on taxes payable now and in retirement, as well as certain tax credits, most households can benefit from paying attention to it, to create new money for investments.”