Our last column explained how the goal of income splitting is to lower the household tax bill. We also highlighted the importance of understanding the “attribution rules” and the importance of seeking professional advice prior to implementing any income splitting strategy. Today, we’re outlining some income splitting strategies with your spouse.
Employ Your Spouse
This strategy is applicable to those individuals who own a business. Wages paid to your spouse may be a deductible expense for your business provided services are being performed. Your spouse would include the wages earned as employment income. This strategy moves income from the higher-income spouse operating the business who is in a higher tax bracket into the spouse who is in a lower tax bracket. If the lower-income spouse has little or no income, then the tax benefits of income splitting should be compared with the potential cost of losing any credits.
The spouse with the higher income can make a spousal RRSP contribution to a plan in the name of the lower income spouse. The higher income spouse receives the deduction however the funds accumulate for the benefit of the lower-income spouse. Some individuals may feel that spousal RRSPs will no longer be applicable if pension splitting is allowed. Unless you can predict your future we would disagree. There may be an opportunity for you to retire at a younger age than expected. Possibly you will need some funds from your RRSP for emergency purposes. Attribution Rules apply if withdrawals are made from the spousal RRSP in the year of the contribution and the following two years.
With today’s low interest rates you can arrange a loan from a higher-income spouse to a lower-income spouse at what is referred to as the prescribed interest rate (set by the government). That loan rate is locked in until the loan is paid off. The lower-income spouse then invests the loan proceeds in their own name to generate investment earnings.
The interest on the loan is deductible to the spouse paying the interest but must be included in income by the other spouse. For this reason, the investment income earned by the lower income spouse must be in excess of the prescribed loan rate for this strategy to be effective and beneficial. For example, based on a 3 per cent prescribed rate, the lower income spouse would have to be earning a rate of return in excess of 3 per cent for this to be advantageous. Be sure to properly document the loan. Consider a promissory note signed by the borrower, detailing the date, amount, interest rate charged, terms of repayment and when interest is due. Attribution Rules: Income will not be attributed back to the lending spouse as long as the interest owed on the loan is paid by January 30th of each following year. If this payment is missed the loan will be invalid and full attribution occurs for that year and all future years.
Service Canada will allow you to split up to 50 per cent of your Canada Pension Plan benefits with your spouse. To determine if this income splitting opportunity would be beneficial for tax purposes, it is necessary to estimate both incomes for the current and future taxation years.
An easy strategy to implement is to have the higher-income spouse pay all the family bills and expenses (including groceries, credit cards, mortgage, property taxes, insurance, etc.). This allows the lower-income spouse to make investments with their capital. The income on those investments is taxed to the lower-income spouses at a lower-rate. The potential income in the hands of lower tax rates can be significant over time.
Annual Tax Bill
The higher-income spouse should pay any income tax liability owing from the lower income spouse. In addition, the higher income spouse could pay any installments that are due. The lower-income spouse should invest any income tax refunds, if applicable.
Third Party Loans
If the lower income spouse takes out an investment loan from a third party, the higher-income spouse should consider paying the interest portion of the loan. The interest the higher-income spouse pays will be deducted on the lower-income spouse’s income tax return.
A less popular income splitting strategy is to swap non-income generating assets for income generating investments. One example may be for couples that have joint ownership in their personal residence. The lower income spouse could sell a portion (or all) of their interest in the residence to the higher income spouse. The lower income spouse may invest the proceeds in income generating investments. Another example, the lower-income spouse could exchange jewelry for income generating stocks or bonds of the same value from the higher-tax spouse. This strategy could result in capital gains being realized. Details of the transaction should be clearly documented.
Prior to implementing any income splitting strategy we recommend individuals meet with their professional advisors.