Depending on our family situation, income splitting may be an effective tax-planning strategy for your household come year end; especially within the current low-interest-rate environment.
This practice is the transfer of income from a family member in a high tax bracket to a family member in a lower tax bracket, which often helps to reduce a family’s overall tax exposure in a given year.
Couples with varying incomes—including parents with children and business owners—are prime candidates for income-splitting strategies. Year end is also the best time for families to work with their advisors to make any final income-splitting moves for the year and to plan for the year ahead.
“The end of the year can be a good time to review income-splitting strategies because it’s when we generally take stock of what has transpired during the year and we start to think about the future,” says Mark Skeggs, vice-president of wealth planning at Gluskin Sheff. “By re-evaluating your circumstances, you might come across an imbalance that you can take advantage of.”
Here we discuss some of the different income-splitting opportunities—ranging from spousal loans and spousal registered retirement savings plans (RRSPs) to options for business owners—that you can consider as part of a holistic, tax-advantaged wealth planning process.
Personal income splitting options
There are several income-splitting options for couples and parents, including spousal loans, spousal RRSPs and pension income-splitting, as well as prescribed rate loan family trusts.
Each option depends on a family’s circumstances and wealth planning goals.
1. Spousal loan
A spousal loan allows a high-income earning spouse to lend money that they otherwise would have invested in their own name, and had the resulting income taxed in their hands at a higher marginal tax rate, to their lower-income earning spouse to take advantage of their spouse’s lower marginal tax rate.
To avoid punitive tax results, the loan must bear interest at the Canada Revenue Agency’s prescribed interest rate (set at 1% for Q4 2020 and Q1 2021) and the interest on the loan must be paid within 30-days of the end of the calendar year.
Ideally, the strategy plays out with the lower-income spouse investing the funds to earn a higher rate of return than the prescribed interest rate, with the difference being taxed at their lower marginal tax rate. The higher-income earning spouse has to pay tax on the interest income received on the spousal loan.
“If someone has a lot of available non-registered funds personally, it can make a lot of sense if there’s a tax-rate differential,” says Mark Chan, vice-president of wealth planning at Gluskin Sheff.
Another major benefit of the spousal loan, Chan says, is that the prescribed rate in effect at the time the loan is made remains for the life of the loan, which is why it’s an attractive option for many couples in today’s low-interest-rate environment.
2. Prescribed rate loan family trust
Individuals subject to tax at the highest marginal rates can also consider setting up a family income-splitting trust. Similar to the strategy above, this would involve a prescribed rate loan being made to a trust, often with a spouse, children and/or grandchildren as income beneficiaries.
The income earned in the trust is then allocated to the child and taxed in their hands, which traditionally would be at a significantly lower marginal tax rate.
Parents and grandparents can use the income generated from this strategy to fund a child’s expenses, such as private school or post-secondary tuition.
“It’s a great opportunity, especially while the prescribed rate is low, to set up a structure that can not only help you today, but into the future,” Skeggs says.
3. Spousal RRSP
Other income-splitting options include spousal RRSPs and pension income splitting. With a spousal RRSP, the higher-income spouse (often with more RRSP room and in a higher tax bracket) contributes to the spousal RRSP and receives the tax benefit against his or her income. The goal is for couples with varying incomes to save for retirement and split income to reduce taxes.
“It’s really designed for a two-spouse household where you anticipate that, in retirement, one spouse is expected to be in a higher tax bracket than the other,” Chan says. “It can help to normalize the household’s retirement income levels.”
4. Pension income splitting
With pension income splitting, a higher-income spouse transfers up to 50 per cent of their eligible pension income to their lower income-earning spouse. Couples can also split income from their Registered Retirement Income Fund (RRIF) if they’re age 65 or older.
5. Registered Education Savings Plan (RESP)
RESPs are also considered an income-splitting option for parents. While parents, guardians or grandparents or don’t receive a tax deduction for their contribution to the RESP, it does trigger a government top-up grant and the contributions grow tax free in the plan. When funds are eventually taken out of the RESP, the income generated within the RESP gets taxed in the hands of the child, who will also have their corresponding tuition tax credit.
“Given that the child isn’t likely to have a lot of income during their college or university years, it’s likely they will pay little or no tax on the withdrawals,” Chan says. “It’s a very enticing income-splitting opportunity.”
6. Registered Disability Savings Plan (RDSP)
The Registered Disability Savings Plan (RDSP) is intended to provide long-term financial assistance to a person that is eligible for the disability tax credit. Similar to the RESP, contributions to the RDSP will trigger government grants. When funds are eventually withdrawn, any government grants and investment income earned within the RDSP gets taxed in the beneficiary’s hands.
7. Funding household expenses
Generally, it is beneficial to have the higher-income spouse pay the majority of the household expenses. This will allow the lower-income spouse to invest more of their earnings and have the resulting investment income taxed at their lower marginal tax rate.
However, there are different considerations for spouses when one earns their income through a corporation.
Business owners and income splitting
The rules for income splitting for family members in businesses have tightened in recent years, but there are still ways for individuals to take advantage of tax-efficient strategies.
Today, business owners can split income by paying family members a salary or wages that is reasonable in light of their contributions to the company.
Dividends can be paid to family members from the corporation, however business owners must be aware of recent tax changes that limits the ability to do so on a tax-efficient basis. A spouse or child receiving dividends needs to be active in the company, contributing an average of 20 hours per week throughout the year, or in any five prior years.
There are exceptions to this active component for family members age 25 or older that own 10 percent of the votes and value of the company, but the rules don’t apply to certain professions. There is also an exception for paying dividends to a spouse or partner of a business owner who is age 65 or older.
Chan says the rules are complicated and encourages business owners to discuss these strategies with an advisor to ensure they’re abiding by the rules as well as maximizing their income-splitting opportunities.
When it comes to funding household expenses, in situations where one spouse earns income from a private company and the other spouse is employed outside the family business, it may be beneficial to use the latter’s employment income to pay for household expenses in order to preserve the tax deferral by leaving income subject to lower corporate tax rates inside the private company.
For business owners in particular, Chan says the year-end is a good time to have these discussions since there may still be time to determine remuneration for the current year, as well as plan for the year ahead.
That said, Chan also believes both business owners and couples shouldn’t just wait until year-end do to their tax planning.
“We see tax planning as something that should be considered all year long, to ensure your financial affairs are well taken care of,” he says.
For more on income-splitting strategies, please download our guide.