Income Splitting: How Does It Work?

February 26, 2024 | Category:

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Taxes are one of the necessary evils in life, but they can put a significant strain on your finances, especially if you are not expecting them.

One option to help alleviate the burden is something many married couples or common-law partners do: Income splitting. Ultimately, income splitting, or pension splitting, is designed to reduce a household’s overall tax bracket. Only eligible pension income is authorized to be split in this way.

This article will examine what income splitting is, its benefits and which income is eligible so you can make an informed decision.

Income Splitting: An Overview

Income splitting is a common practice where the higher-earning partner transfers a part of their income to the lower-earning partner. For tax purposes, this will put both partners on similar income levels. You can split up to 50% of your eligible pension income with your spouse or common-law partner and reduce the overall tax owed by your household.

Regardless of your age, setting up your income split early can set you up to make income splitting easier in the future to plan for your retirement. One critical detail is distributing the savings instead of having them sit in one place, making them more vulnerable to higher taxes. 

If all of your savings would go into, for example, one RRSP (Registered Retirement Savings Plan), you would face a higher tax burden than if you distributed the savings into two or more plans.

In today’s complex financial landscape, the role of accounting services extends far beyond mere number crunching. These services play a pivotal role in strategic financial planning, especially when it comes to optimizing tax strategies like income splitting.

Benefits of Income Splitting

The most significant advantage of income splitting is reducing your household’s income tax burden. All couples with disparate income levels can benefit from income splitting, but it is particularly beneficial for high-income earners. This will become particularly relevant once you retire as you will likely receive income from investments, which can put you into a high tax bracket. Income splitting can lower your tax bracket and increase your spouse’s, allowing you to reduce your tax bill.

But there is another benefit of income splitting. The Canadian government has the Pension Income Amount, a tax credit worth $2,000 for any retiree with an eligible pension amount. So, the first $2,000 of your annual pension income is tax-free if you are in the first tax bracket.

Additionally, your spouse who is not receiving a pension can claim the same tax credit, meaning both can receive these $2,000 in pension tax credits.

How Income Splitting Works

Income splitting is an electable action you must opt into every year you file your taxes. Both you and your spouse must complete and file the CRA’s form T1032, Joint Election to Split Pension Income. 

The idea behind income splitting is to take advantage of Canada’s progressive tax system, which imposes higher tax rates on higher income levels. Through the T1032 form, you can allocate part of your income to lower-income family members, effectively reducing your overall taxable income and tax bill.

There are several methods and rules for income splitting in Canada, including:

  • Spousal Loans: This involves lending money to a lower-income spouse or common-law partner and charging interest. The lower-income spouse can then claim the interest income, effectively splitting the taxpayer’s income.
  • Family Trusts: A family trust is a type of trust that allows for the income generated by the trust to be allocated to different family members. Using a family trust, you can allocate income to lower-income family members and reduce your overall tax bill.
  • Investment Income Splitting: This involves holding investments in the names of lower-income family members. The income generated by these investments can then be claimed as income by the lower-income family members, effectively splitting your income.

The rules and regulations surrounding income splitting are complex, as the CRA has laws in place to prevent taxpayers from artificially using income splitting to reduce their tax bill, and taxpayers who engage in improper income splitting may face penalties and fines.

Income Eligible for Splitting

It is critical to remember that not every type of income is eligible for income splitting. If you and your spouse are under 65 years of age, your qualified income is limited to the Registered Pension Plan payments or annuities and benefits you received due to the death of a spouse.

You and your spouse also must reside in Canada and live together during the tax year for which you are reporting the income split to be eligible. So, if you are separated and are not living together at the end of the tax year, you cannot split your income. There are some specific exceptions when one of the partners lives abroad or is separated due to medical, educational or business purposes.

Eligible types of income are:

  • any income derived from a Registered Retirement Income Fund (RRIF) or an RRSP
  • life annuity income

Amounts from an RRIF included on line 11500 and then transferred to an RRSP, another RRIF, or an annuity are an exception to this rule.

Any government benefits, such as Old Age Security payments and income derived from the Canada Pension Plan or the Québec Pension Plan, are not eligible for income splitting. Similarly, income from a United States individual retirement account is also not eligible.

How Can an Accountant Help?

The Certified Professional Accountants of Stratos Accounting and Consulting can help you navigate rules and regulations to maximize your benefits and tax credits and avoid potential fines or penalties. With over 15 years of experience in accounting, Stratos’ accountants will diligently use their deep knowledge of the ever-changing Canadian tax laws to provide you with the best possible advice and service.

Stratos Accounting & Consulting is your professional choice for dedicated, personalized, customized services. We strive to provide our clients with exceptional customer service and always be available to answer questions and provide guidance. Our experienced professionals work closely with our clients to understand their unique needs and objectives and develop solutions tailored to their specific situations.

Our company is built upon five pillars: Integrity, Professionalism, Respect, Quality and Transparency.
Contact Stratos Accounting & Consulting today at 416-477-4775 or fill out our convenient online form to learn more about how Stratos can help your business soar.

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