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Income Splitting Part Two

Family Budgeting

Perhaps the simplest and most effective technique to split family income does not involve income tax; rather it is the process a family uses to spend, save and invest. In order to implement this strategy, the spouses must be in different tax brackets. Assume the husband’s annual income is $85,000 and the wife works part-time and her take-home pay is $10,000. The responsibility for paying specific expenses varies by family, but it is not uncommon for higher income spouses to use excess funds for investment purposes. If the husband currently invests $10,000 per annum from his salary and the wife uses her part-time earnings for household and personal expenditures; an income-splitting opportunity exists. The lower income spouse could invest the $10,000 from her earnings and the higher income spouse would pay for the expenditures that were formerly made by his wife. The strategy would result in the investments being owned by the wife and taxed at her lower marginal tax rate.

Pensions

There are income splitting opportunities for both regular pensions and the Canada Pension Plan. The ability of spouses to split pension income is the best tax planning tactic for retired couples. In order to split pension income, both spouses or common-law partners must make a joint election on Form T1032, Joint Election to Split Pension Income and submit it with their tax returns. An individual can elect to split up to 50% of the eligible pension income.
There is a pension credit of $2,000, but it can only be claimed against pension income. If only one spouse has income from a pension, by transferring a portion of the pension to one’s spouse, both spouses can claim the credit of $2,000. In addition to the pension credit, transferring income to the other spouse results in the pension being taxed as her lower tax rate.

Canada Pension Plan – There are limited income splitting possibilities with Canada Pension Plan payments. In order to share pensions, both spouses must be at least 60 years of age and agree to share their pension with each other. Spouses are allowed to share Canada Pension Plan payments based upon the amount of time they lived together as spouses. If a couple lived together for 75% of the period when they contributed to the Canada Pension Plan, they could share 75% of their monthly payments. If both individuals were receiving the maximum benefit, there would be no advantage to this strategy. This strategy is effective when one spouse receives the maximum monthly CPP pension and the other had either insufficient income or number of years in the workforce to achieve the maximum payment. By sharing the CPP, pension income can be transferred to the low-income spouse.

Prescribed Rate Strategy

Given the current low-interest rates, this strategy may be the most effective income splitting strategy that has been available for a number of years. One of the exceptions to the attribution rules is that if money is loaned to a spouse or child under the age of eighteen at a rate of interest equal to or greater than the prescribed rate of interest the attribution rules will not apply. The tax department has announced that the prescribed rate of interest for the first quarter of 2018 will be 1%.
Consider the following example, a high-income individual loans $100,000 to his spouse who does not work outside the home. The rate of interest on the loan is 1%. For this strategy to be effective, the loan must be reinvested so that the rate of return exceeds the rate of interest charged on the loan. In other words, the low-income spouse must invest the funds to receive a rate of return in excess of 1%.

Returning to our example of a $100,000 spousal loan, if it was invested at a 4% rate of return, not only would the $4,000 be included in the income of the spouse who does not work outside the home, the dividend tax credit and personal credits may totally eliminate the tax.

In order to ensure this strategy is not attacked by CRA, there are a number of rules that must be followed. These include:

• the rate of interest remains frozen as long as the loan is outstanding
• the interest on the loan must be paid either during each calendar year, or by January 30 of the following year
• returning to our example, the higher income spouse must include the $1,000 of interest earned on the loan in income on an annual basis. The lower income spouse must include the $5,000 in income, but can also claim the $1,000 of interest paid to her spouse as an investment expense
• if the amount of the loan is material, it would be wise to have professional assistance to draw up the loan agreement. It should be drafted as a demand loan

Tax Free Savings Accounts

Many taxpayers make an annual contribution of up to $5,500 to their Tax Free Savings Account and the obvious advantage is that any interest, dividends and capital gains are not subject to tax while in the plan or at the time the funds are withdrawn. However, they are also an effective means for family income splitting. For example, high-income spouses can not only contribute $5,500 to their plan but can gift the same amount to a spouse and/or adult children. The attribution rules do not apply to such gifts. Thus, if one of the spouses lacks the income to invest, the higher income spouse should make a $5,500 annual contribution to a Tax Free Savings Account for both himself and his spouse.

Registered Educational Savings Plans

An individual, normally a parent, can make a contribution of up to $50,000 per beneficiary. The investment income on the contribution is not taxable until it is eventually withdrawn from the RESP to fund the student’s education. However, the funds are taxable to the student, rather than the contributor. In many cases, the student’s tuition and personal credits may eliminate any tax on the investment income generated by the RESP.

Spousal RRSP

If a couple believes that one spouse will have a higher tax rate in retirement, the spouse with the higher rate can make a contribution to a spousal RRSP. This provides a current deduction for the higher income earner and the lower income spouse will pay tax on the income from the RRSP when it is eventually collapsed as a RRIF or an annuity. This tactic has been a staple of many families financial planning for years, but it has become less common with the ability to split pensions income.

Taxable Dividends

If an individual can claim a spousal credit, any dividend income earned by the lower income spouse may reduce the amount of this claim. Since the dividend is grossed up this further reduces the claim. If the spouse has no taxes payable, the dividend tax credit cannot be utilized as there are no taxes for the credit to offset. However, the higher income spouse has the option to include the dividends in his income, if this will minimize the spouse’s combined tax liability. This strategy works very well in combination with the prescribed rate strategy that generates dividend income for a stay at home spouse.

Optional Spousal Claims

There are certain deductions or credits that can be claimed by either spouse. This does not represent income splitting in the true sense as the total taxes payable by both spouses may remain unchanged, but there may be certain advantages depending upon which spouse makes a claim. In addition to possible tax savings, there may be cash flow considerations, as it can impact the size of potential refunds and the quarterly tax installments for the next calendar year. Deductions and credits that may be claimed by either spouse include:

Charitable Donations – It is CRA’s policy to allow spouses to claim their own charitable donations plus those made by their spouse. As a result, a family is in a superior tax position if the spouse with the higher income claims all the charitable donations for the family.

Safety Deposit Box – If a family has investment income and maintains these investments in a safety deposit box, the cost of the box can be claimed as a deduction. Since either spouse can claim this deduction, the individual in the highest marginal rate should make a claim.

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