It takes money to make money.
Build a big nest egg is similar to how a dragon grows its hoard of jewels, gold, magical items, and skulls of vanquished foes. It takes having some treasure to grow more. In the case of a dragon, a large pile of treasure attracts brave adventurers who usually bring with them more treasure to add to your pile and more bones to lay on after having a quick meal.
A large hoard also attracts undesirables.
The problem with accumulating a mountain of treasure is that it gets harder to defend from the sneaky little creatures that will inevitably come and nibble away at the edges. Hobbits are famous for this. They are stealthy, have hairy feet, and live a generally leisurely life that revolves around multiple meals per day, smoking weed, and living off of the bounty of the Shire. Any resemblance to real persons is purely coincidental.
Dividing up your treasure pile with a mate makes it easier to grow and defend.
Intermediate-term income splitting strategies are aimed at evenly distributing income between partners in the years before turning age 65. That minimizes tax drag both while building up the treasure hoard and also when eventually drawing upon it.
These techniques revolve around building up an investment portfolio to generate income taxed in the hands of a lower income spouse. One method is with spousal RRSPs, as just reviewed. However, those with a larger portfolio may need more room than an RRSP can provide. Plus, there are some tax advantages to using TFSAs, Corporate, and non-registered “taxable accounts” as part of your comprehensive investment plan.
In this post, we will discuss:
- Whether you need to consider intermediate term income splitting strategies
- A brief overview of the attribution rules.
- How to build the foundation for intermediate-term income splitting by maximizing your lower income spouse’s investment capital.
When an intermediate-term income splitting strategy may help:
1) If your income and your spouses’ income now are in radically different marginal tax brackets during your asset building years.
2) If your projected income in retirement will put you in radically different marginal tax brackets as you draw from your nest egg.
It is important to consider any work pensions that the lower earning spouse may have. This is most important if you plan on retiring before 65. After 65, income splitting via pensions, RRSPs, and CCPCs (professional or private corporations) becomes easy again.
Unless they change the rules again. Personally, I am not taking anything for granted on that aspect. The demand for tax revenue is going to increase in step with the strain to fund the entitlements of the population for government services. I don’t want all of my eggs in one basket.
3) If you anticipate the need for more money than your RRSP, TFSA, and CCPC provide to fund your retirement lifestyle.
This is becoming increasingly important for professionals. Our earning years often start later and the first few years are spent repaying debt. That means that we need to have a high savings-rate to generate a retirement fund over a more condensed career span.
The amount that we can save in RRSPs is truncated. Both by fewer income-earning years and a cap on the maximum annual contribution allowed. It is well below 18% of our incomes and we should be saving at least 20%.
This hits especially hard if you plan to “retire early”. The amount that we can save in a CCPC has also been blunted by the new passive income tax limits. The other factor is spending, and we may need sizable portfolios to fuel the lifestyle that we have worked hard to achieve and have grown accustomed to.
To achieve that portfolio size, you may need a taxable investment account. You will want it taxed at the lowest rate possible.
4) You are not incorporated and will need more space than your RRSP and TFSA provide.
The same reasons as number 3. In many ways, this is a more useful technique for unincorporated professionals than incorporated ones.
Professional corporations do offer partial tax deferral (~85% for small ones and 75% for those making >$500K/yr). The loss of tax deferral from taking money out of a corporation to preserve a low income spouse’s income for investing needs to be considered.
That is not an issue for those without a corporation. It was an issue in our case. For those with a corporation, the loss of some tax deferral may be worth the piece of mind of having their assets better spread out to guard against legislative tax risks.
Does income splitting your taxable investments matter?
Let’s look at a quick example. Say, you are a specialist physician and drawing an income of $400K/yr while your spouse makes 50K/yr. You use up your tax-sheltered accounts to hold your tax inefficient bonds part of your portfolio.
You are building some money in the corporate account but will hit the passive investment limits in short order. You could cut back working at that point, but will still be pretty young and not ready to yet. Being proactive, you could also invest 50K/yr in a taxable account in an ETF tracking the TSX earning an average of 5%/yr capital gain (which you don’t trigger extra tax by cashing in) and 2.6% eligible dividends. That is pretty tax efficient.
After 35 years you would have $6.3M if invested in your taxable account compared to $7.2M if invested by your spouse instead. Almost $1M difference. That is a pile of loot, even when you adjust it down for 35 years of inflation.
This is with the lower earning partner earning $50K/yr – it is even more dramatic if they have little or no income. This model is also assuming that you did not realize any capital gains over the accumulation span. If you did (most do), then that would have triggered tax events. Those would have a much greater detrimental impact taxed in the higher income spouse’s hands.
Drawing money via a lower income spouse is also quite important if you plan to retire early.
Let’s say in the above situation that you and your spouse decide to retire at age 55. For simplicity, we’ll say that you each draw $25K income from your RRSPs (which you have built to equal sizes). You also draw $50K/yr from your CCPC as dividends and your spouse draws $50K/yr from the dividends made in her taxable account. Your household after-tax income would be $133K/yr.
If the taxable account was in your name, then your after-tax income would be $124K/yr. You could even things up when you hit age 65, but that is about $100K in lost cash flow in the decade leading up to that.
The Dreaded Attribution Rules
Gifts in Canada are generally not taxed. However, to prevent the avoidance of tax by high earners gifting money or capital property (like real estate or stocks) to their lower earning family members (spouse or a minor child/grandchild/niece/nephew) to generate income from, we have the “attribution rules”. Notably missing from the list are parents and siblings.
These rules are to ensure that income generated from such gifts is attributed to the higher-earning spouse and therefore taxed more. Let’s look at a few examples.
Gifts to a Spouse
- If you give money, stocks, or a rental property to a lower income spouse, then any income (dividends, interest, rent, royalties) will be attributed to you to be taxed at your rate.
- If the property gains in value from time of purchase, all those capital gains will be attributed to you.
- You can avoid some of the gains being attributed to you if you file a special election with your tax return for the year that the gift is given. That special election would result in you paying capital gains on any increase in value to that point as if you had sold it to your spouse at fair market value (FMV). If it appreciates further after that, then your spouse would only pay capital gains tax on the increase above that FMV.
- Another notable nuance: Income generated from the income (second generation income) is not attributed. More on this in a follow-up post.
Gifts to a Child, Grandchild, Niece, or Nephew
- The gift is considered to be sold by you at FMV when given.
- If the recipient is a minor (under 18), then you have to report any income (dividends, interest, rent, royalties) generated by the asset and it is attributed to you. Once they turn 18, the income can be attributed to them.
- A notable exemption: capital gains are taxed in the hands of the recipient rather than the contributor.
Loans Instead of Gifts
- If you make a low or interest-free loan to a spouse or minor, then income from whatever is purchased with the loan is attributed back to you.
- Exemption: If you make the loan at the CRA prescribed rate (still a measly 2%) and the recipient pays that interest from their own funds, then the attribution rules do not apply. You need to claim that interest paid as income on which you are taxed and you also need appropriate legal documents and record keeping. We’ll delve into this one in another post.
- If your spouse or minor child obtains a loan based only on the strength of your guarantee for the loan, then the attribution rules apply to income generated by assets purchased with that loan.
Depressed or worried yet? Don’t be. Time to “Dragon-up”.
The thing is, dragons are legendary not only for their greed. They are also characterized as being lazy and liking to simply slumber laying on their treasure heap. Most professionals and other successful people in my experience are not particularly greedy or lazy. Most of us did not simply find or inherit treasure. However, since we have been painted like greedy dragons by the recent government tax campaigns, maybe we should go with it.
Dragons have plenty of natural weapons at their disposal to eat burglars and even cook them up a bit first. We have strategies that we can use to prevent the CRA Warrior from using Attribution against us while sharing our hard earned riches with our mate and our clutch of little dragonettes.
To take full advantage of intermediate-term income splitting techniques with your spouse, they need some treasure to attract more for their pile:
- They need to generate some income of their own.
- That income needs to be preserved so that it can be leveraged.
- It needs to be isolated from your joint income and assets so that it is not soiled or tainted by you. My wife feels the same way about her bed pillows.
How To Build Your Lower Income Spouse’s Mountain of Glittery Capital To Leverage and Invest For Intermediate-Term Income Splitting
- Your lower income spouse needs to open their own bank account separate from your joint account.
- Their income should be paid directly into that account.
- They need an income. This could be from their job outside of the business, paying them to do work for your business (being your billing agent is low hanging fruit), or money is withdrawn from a spousal RRSP that hasn’t been contributed to in the preceding two calendar years.
- You need to preserve their income to be used for investing. To do this, the higher-earning spouse should pay for all living expenses using their joint account. This includes paying their income taxes that haven’t already been collected at source.
- They need to set up a separate personal taxable investment account in only their name.
The thing is, if you start poking a dragon sleeping on its treasure, it may wake up.
Now that we have awoken, let’s flex our talons, light the fire in our bellies, and get serious about defending our hard earned money.
With the foundation laid, we will examine how to use it to increase the size of their income in the next few posts.