The main objective of income splitting is to evenly distribute taxable income between a higher and lower taxed spouse. With Canada’s personal income tax system, that may reduce your household tax bill. If all income in a household flows to one partner, like a high-pressure hose, much is lost to taxes.
Spreading the income between both partners keeps marginal tax rates as low as possible. Like a sprinkler. Less evaporates via the tax bill and more soaks into the soil of the family plot to nourish your family. Learn how to plan your household’s financial irrigation system to grow your family’s financial garden. Even in the Canadian climate.
Different Income Splitting Strategies For Different Timeframes
Different strategies are used to income-split over different time horizons. In the short-term, you can try to redirect earned income to a lower income spouse to minimize the current year’s tax bill. An intermediate term strategy aims to grow the income-producing assets in a way that attributes the passive income to the lower taxed spouse. That takes time, but as passive income grows, it will grow more if it is taxed lightly. After the age of 65, income-splitting becomes easy. However, building your short and intermediate-term strategies gives you more options before then.
Short-Term Income Splitting
The main short-term objective is to try and have both partner’s income as close to each other as possible. The bigger the difference between you and your spouse’s base income, the larger the potential benefit. If the income levels are close, or both spouses are already in the highest marginal tax bracket, then there is little benefit.
Business owners or high-income professionals have several options to help even out their incomes within the family. Most are available to anyone, whether incorporated or not.
Hire your spouse and pay them fairly.
You don’t need to be incorporated to hire a spouse to do work for your business. It is a great way to income split and re-direct revenue towards a lower-taxed spouse. Not only does hiring a spouse allow you to income-split, it also keeps that money in the family rather than paying an outside expense. If it is a task that you would normally do yourself, it can free up some time for work that you get paid more to do. Using your spouse for billing and book keeping is low-hanging fruit.
The key is that it must be paid at a fair market rate. So, you cannot pay them $100K for some book-keeping or billing that you would pay someone else $20-40K to do. The other flag for CRA is if you try to hire them as a contractor rather than an employee. The CRA wants you to pay them regularly and remit payroll taxes regularly.
Income splitting using dividends.
If you are incorporated, then it may be possible to income split using dividends. The advantage of using dividends is that they do not need to be market rate. You could give a large dividend to shift income. Since the new tax on split income (TOSI) rules of 2018, that is harder to do. However, it is still possible in some situations.
For incorporated physicians or other service-oriented businesses, you can still income-split with dividends if your spouse is a non-voting shareholder and legitimately works >20h per week for the business. That threshold needs to be met either in the year that the dividend is issued or if there have been five full years of the threshold being met. Those don’t need to be consecutive years. Payroll records and a well-kept work log makes sense as evidence, but the rules are still quite new and we haven’t seen how they are audited yet.
After the active owner of the corporation turns 65, they can income-split with a spouse again without triggering the TOSI rules.
Using the Spousal RRSP for semi-short-term income splitting.
Spousal RRSPs are an income splitting option available to all Canadians. The higher-income spouse can contribute and drop their taxable income in the year of contribution. In the highest tax bracket, that could mean a 54% savings in some provinces.
After a 2-3 years lag of not making contributions, the lower-income spouse can take that money out, taxed in their hands. If taken out before that lag, the income would be attributed back to the contributor. This limits the utility of spousal RRSPs for short-term income splitting. However, it can be useful for intermediate-term goals like funding a parental leave or sabbatical where your spouses’ income drops dramatically. That does require you to plan in advance. Even if you are not anticipating your spouse having a low-income year, it could happen. Using a spousal RRSP may give more options, if it ever does.
Intermediate-Term Passive Income Splitting
Developing an intermediate-term income splitting strategy revolves around having a lower-income spouse develop a portfolio of income producing assets. Building an income-machine attributed to them means passive income taxed at their lower rates. Notice in the chart below that the next most tax-efficient growth, after an RRSP/TFSA, occurs in a personal account at a low tax bracket. Plus, it does not have an embedded liability from tax deferral and was taxed lightly to get there. There are a few big questions to consider for intermediate time horizon planning.
Do you have what it takes for intermediate-term income splitting?
You need personal money to invest.
To develop passive income streams for a lower-income spouse, they must have excess personal money to invest. That means that your household spends less than it makes. For building a lower-income spouses’ passive income to matter, you also need money left after taking advantage of your tax-sheltered accounts (TFSAs and RRSPs).
That comes from spending within your means consistently. However, you may also want to consider this if you get after-tax windfalls like an inheritance, gift, or proceeds from a major sale. Incorporated professionals may also pay themselves extra salary to get RRSP room or dividends to release refundable taxes to their corp. That can be used to cover household costs while preserving their spouse’s income for investing. The corporation may also be able to pay out a tax-free capital dividend to a lower-income spouse since it is non-taxable and avoids the TOSI rules.
You also need to accept functioning as a financial unit.
That means accepting optimizing who pays and who builds the assets in their name as opposed to trying to evenly split costs and ownership. The reality is that if you split up, everything is shared whether you co-operated and shared or not. So, it is better to optimize and build a larger pot regardless. Plus, couples who pool their finances are more likely to be happy and stay together.
You need to be comfortable with the high-income earner paying for all living expenses and TFSA contributions from a joint account. That preserves the lower-income spouse’s money to invest without triggering the attribution rules.
Does an intermediate-term income splitting plan help you?
Larger income difference, longer time horizon, and more disposable income = more useful.
If there is a large income difference and you are able to build a large personal account attributed to the lower-income spouse, then that progressively makes a larger difference as it grows. So, a big income spread and a long run-way make it more important. The more after-tax money you have to invest, the bigger difference it makes.
In contrast, if the income difference between the spouses is minimal, then it may not be worth the effort. Further, having only joint accounts makes the transition of assets instantaneous and seamless in the event of one partner’s death.
Whether you plan to retire early or want more flexibility in case life throws you a curve-ball before age 65, intermediate-term income splitting can help.
After the owner turns 65, a corporation can income split between spouses again. Similarly, when over age 65, split the attribution of income from RRIFs and pensions to save on taxes. However, if you need to draw from your portfolio before that age. Having a pot for a low-income spouse to draw from at a lower tax-rate is great.
Even though you can pension split an RRIF, it is limited to 50%. So, using a spousal RRSP is still a way to have more than half of your household RRSP/RRIF income in the hands of a lower income spouse. That could matter if the high income spouse has a large mandatory retirement income from other sources.
You may intermittently need large cash outflows to pay for a splurge. Maybe a cottage or a big honkin’ motorhome to vacation in. Having a pot of after-tax money to draw from instead of pulling money out of your corporation and triggering taxes can be helpful. If capital gains are realized to free up cash, they are lightly taxed in a low-incomes spouse’s hands.
What tools can you use for intermediate-term income splitting?
The main strategies are summarized in the flow diagram above. The high-income spouse’s income goes into a joint account from which they pay all living expenses and extra tax installments. Those are expenses and do not affect the attribution rules. The higher-income spouse funds both TFSAs (no taxable income) and they must fund the spousal RRSP owned by the lower-income spouse.
A clean trail showing that the lower-income spouse is investing their earned income makes the subsequent investment income taxable in their hands. So, their paycheck goes into a personal account from which they fund their personal investment account and RRSP.
If they don’t have much income, a spousal loan could be a way to provide them with money to invest. A loan secured against a joint asset (such as a mortgage or HELOC) can also be used to fund their personal account and make the interest a deductible expense. Home equity for income-splitting.
We have personally used all of these strategies except for a spousal loan. It is a gradual process, but bears fruit mid to late career. The current distribution of our net worth in mid-career illustrates that. About a third is in our corporation, my wife has a third personally, and our registered accounts are pretty evenly split for the remaining third. This gives us less tax-drag on growth now and more options to withdraw money before age 65.
Long-Term Income Splitting In Retirement
Income splitting during traditional retirement actually gets a lot easier. Perhaps because people over 65 get out, vote, and make optically poor targets for politicians.
You are able to pension split income from RRSPs/RRIFs and CPP. A defined benefit pension is readily split up to 50%. However, a defined contribution pension must be converted to a Life Income Fund (LIF) or Locked-In Retirement Fund (LRIF) for the income to be split. Even dividends from your CCPC can be used because owner age >65 is an exclusion from the TOSI rules.
Even though it is easy to income split when you are over 65, it is still probably be prudent to have your assets as evenly distributed as possible in the years leading up to this.
That makes it easier if you decide to retire or semi-retire earlier than age 65. Retiring earlier requires a larger nest egg to survive a longer drawdown period. So, decreasing the drag of taxes by taking advantage of a lower-income spouse’s lightly taxed investments helps. Further, the ability to draw income from both partner’s investments to minimize the tax during retirement is additive. You may not plan to retire before 65, but you could change your mind for a variety of reasons or be forced to.