People may work for 40 or more years prior to collecting a pension. It is during these years that couples acquire the wealth required for retirement. Minimizing the amount of tax that you pay during this 40-year period is an important component to financial planning. It is often said that it is never too late to start investing for the future. It could also be said that it is never too early to start income splitting.
The Tax Fairness Plan announced by Ottawa relates strictly to specified pension income. This is good news for many pensioners but primarily impacts individuals in their 60’s and older. So, what about those first 40 years? We encourage couples to take advantage of income splitting opportunities throughout their life.
In our last column we gave an overview of pension splitting. Pension and income splitting are similar concepts with the same goal of shifting income from an individual in a high tax bracket to a family member in a lower tax bracket (or not taxed at all if the family member’s income is low enough).
The result for both should be a reduction in the amount of tax the household pays. Income splitting is more encompassing and may include pension splitting and other strategies. Income splitting is a term that may be used throughout your life at any age. Income splitting strategies may extend to your entire family, such as spouse, children, parents.
To understand income splitting fully one has to obtain a basic understanding of the Canadian tax system. In Canada, tax rates increase in stages as taxable income increases. A term that is often used is marginal tax rates. This essentially means the amount of tax that you would have to pay to earn another dollar of income. If one had to pay 26 cents in taxes to earn one additional dollar of regular income, then the marginal tax rate is 26 per cent. This should not be confused with a person’s average tax rate.
Prior to implementing any income splitting strategies it is important to understand the rules. The rules, as outlined in the Income Tax Act, are designed to block your attempts to shift income from you to another person (usually your spouse or family member). These are generally referred to as the “attribution rules”.
Attribution – Spouses
If you transfer or loan property either directly or indirectly (by means of a trust or any other means), for the benefit of your ‘spouse,’ any income or loss from the property and any capital gain or loss on the disposition of the property will be attributed back to you. This means that even though your spouse is receiving the income, the income must be reported on your tax return and will be taxed at your marginal tax rate. Effectively this leaves you and your spouse no better off from a tax perspective.
It should be noted that ‘spouse’ includes a common law partner, same sex couples who have been living together for at least one year and a person who subsequently becomes your spouse.
Attribution – Minor Children
Income on property transferred or loaned, directly or indirectly (by means of a trust or any other means), to a related minor child will be attributed back to you. This rule only applies if the child is under 18 at the end of the year. Unlike the rules for your spouse, it doesn’t apply to capital gains or losses on disposition of the property by the child. Transactions that open up to attribution are those in which a taxpayer and child are not dealing at arm’s length. Children, grandchildren, great-grandchildren, your spouse’s children and your child’s spouse are considered to be non-arms length, as are your brother, sister, brother-in-law, sister-in-law, and your niece or nephew.
Attribution – Adult Children
Funds/assets that are gifted to an adult child do not result in income attribution back to the parent. Parents may have a tax consequence if they gift assets other than cash, as they will be deemed to have disposed of those assets. It is also important to note that once the assets are gifted, they are the child’s to do with what they want.
The above rules may give the appearance that it is very difficult to income split with family members. Fortunately, with a little planning it is possible to divert income to your spouse and children and avoid the attribution rules. Our next two columns will highlight some of these strategies.