Income splitting is a tax term in which the taxpayer income is split to reduce the taxes owing for that taxpayer. Income splitting is a strategy that can be implemented by high-income owners of private corporations to divert their income to family members with lower personal tax rates.
When a private corporation makes a profit, there is a corporate tax on the net profit. When the net profits are disbursed as dividends to shareholders, the individual shareholders are then taxed at a personal level. Personal tax in Canada is taxed in a tiered system, and so the more income earned the higher the overall tax. The idea behind income splitting is to disburse the dividend income among multiple family members so as to reduce the personal tax paid on this income.
What is income splitting?
Let’s say Sarah is married to Justin. Both reside in the Greater Toronto Area suburb of Richmond Hill. Sarah makes $30,000 a year, while Justin makes $90,000. That places Justin in a higher tax bracket than Sarah, meaning that he probably has to pay significantly more than her. However, if Sarah and Justin spread their income evenly among themselves, then their overall tax level will be lower than if they remained at their original corresponding levels.
If Sarah makes $300,000 but Justin only makes $70,000 while they are both in their late 30s, then Sarah will be able to save more, simply because she has more income to put aside. Instead of placing it all into her RRSP, she could put part of it in a spousal RRSP so that, by the time Sarah and Justin retire, their RRSPs would be pretty even and they would have fairly level sources of income during retirement from which they could draw. If they simply drew income from one large RRSP, their tax burden would be higher than if they withdrew from two smaller ones.
Advantages of income splitting
While income splitting is beneficial for all couples who have disparate income levels, it is particularly beneficial for high-income earners who would otherwise be in much higher tax brackets. This is particularly relevant when retirement comes along. Although you might not be working, you will likely be receiving income from sources such as your investment accounts.
Let’s go back to Sarah and Justin. Let’s say Justin and Sarah are retiring, and Sarah has a pretty respectable investment fund that generates about $50,000 in income. Justin’s investment account, on the other hand, generates almost no income. Usually, Sarah would be faced with a pretty hefty tax bill, since she would be in a higher tax bracket. However, if she split that income with Justin on their taxes, then Justin would be pushed into a higher bracket while Sarah would be pushed down, essentially leveling them out and lowering the overall tax burden of their household. Both Sarah and Justin would then report $25,000 each as their individual income; their overall tax bill would be lower as a result.
“You’d want to income split if you’re in retirement and you [and your spouse] end up in different tax brackets,” Alnsour says. “Income splitting will let you reduce your overall tax bill.” The only time income splitting would probably be unnecessary is when you and your partner end up in the same tax bracket during retirement and have similar RSPs or pensions, he adds.
Both of you would also have to reside in Canada, and live together during the tax year for which you are reporting the income split. There are certain exceptions that apply when one of the partners lives abroad or is separated for medical, educational, or business purposes, but for the most part, you have to be living together in Canada. So if Sarah and Justin were currently separated and living apart at the end of the tax year, they would not be able to split their income.
It is also important to keep in mind that only certain types of income are eligible for income splitting. Government benefits such as Old Age Security (OAS) payments, income derived from the Canada Pension Plan (CPP) or the Quebec Pension Plan are not eligible for income splitting. Income derived from a United States individual retirement account (IRA) is also not eligible.
Here is what is eligible for income splitting: Any income derived from a Registered Retirement Income Fund (RRIF) or from a Registered Retirement Savings Plan (RRSP), as well as life annuity income. You can find more detailed information about who and what is eligible for income splitting on the Canada Revenue Service’s website here.
How income splitting works
Income splitting is an electable action that you opt-in on every year when you file your taxes. Both you and your spouse or partner would have to complete and file the Canada Revenue Agency’s form T1032, Joint Election to Split Pension Income.
However, form T1032 is not exactly the most comprehensible of forms, so people will often choose to get help from their accountant, which will help ensure the form is filled out correctly.
After that, you will have to fill out a new form T1032 for every year you choose to income split.
What needs to be considered?
There are many considerations to be made when taking on this tax reduction strategy. There are rules that would prevent simply transferring income from a corporation to various family members. There are rules in place that require family members receiving dividends from a corporation to be at least 17 years of age and be significantly involved in the corporation.
The rules are called tax on split income (TOSI) and if these rules are not followed then the income transferred to the receiving family member may be taxed at the highest income bracket, which then defeats the entire purpose of splitting income.
It is highly advisable to talk to an accountant when splitting income to avoid this exact case of being taxed at the highest income bracket. Furthermore, other tax strategies should also be considered in these types of situations.
A few articles for reference:
Income Sprinkling – https://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/federal-government-budgets/income-sprinkling/frequently-asked-questions-income-sprinkling.html
Tax on Split Income – https://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/federal-government-budgets/income-sprinkling/guidance-split-income-rules-adults.html