Despite some focus under Stephen Harper’s past Conservative government, the ability for Canadian couples to split their income and reduce their family’s overall tax burden remains a challenge in 2020. In this quarter’s Optimist, we review seven opportunities that still exist to share or split incomes.
While progressive taxation is an important tool for reducing the degree of relative inequality within a country, it can result in inefficiencies for couples who have significant variance in the income earned by each spouse.
In Table A, we see the highest marginal tax rate for five provinces, as well as the income level above which that tax rate applies. As we can see, Alberta continues to have the most advantageous tax system for top earners.
As Canadians in many provinces are giving governments more than 50% of each additional dollar earned, these marginal tax rates can seem high. In addition, this system disproportionately and negatively impacts individuals over families.
Province |
Income level |
Combined federal and provincial tax rate |
---|---|---|
Alberta |
Over $314,928 |
48.00% |
Ontario |
Over $220,000 |
53.53% |
Quebec |
Over $214,368 |
53.31% |
Manitoba |
Over $214,368 |
50.40% |
BC |
Over $220,000 |
53.50% |
Table B illustrates the average tax rate and total taxes paid in 2020 under three scenarios:
It is clear from this illustration that despite each of our three families having the same gross income, they are in very different positions after taxes. For example, our successful individual pays upwards of $30,000 per year more in tax compared to the couple with an equal income split, even though their gross income is the same.
Despite our example in Table B, which shows that disparity in incomes can negatively affect Canadian couples, it can be a challenge to reduce tax in a way that stays onside with the Canada Revenue Agency (CRA). In essence, CRA rules require each individual to pay tax on their own income, as well as the income derived from any investments made with one’s savings and capital. In this way, it is not possible to simply “gift” money or investments to one’s spouse and have the investment income taxed at the lower spouse’s tax rate, as CRA would “attribute” the investment income back to the gifter. This could result in significant tax to the gifter, and potentially additional penalties from CRA.
|
Marginal tax rate |
Average tax rate |
Tax payable |
---|---|---|---|
Individual #1 at $400,000 |
48% |
39.42% |
$157,673 |
Couple #1 at $200,000 each |
42.22% |
31.73% |
$126,930 |
Couple #2 at $340,000 each + $60,000 |
|||
$340,000 |
48% |
37.90% |
$1280,873 |
$60,000 |
30.50% |
19.52% |
$11,710 |
Total for Couple #2 |
35.15% |
$140,583 |
In this article, we highlight seven strategies that Canadian couples can consider to more effectively equalize their income and reduce their overall tax burden, while following CRA’s attribution rules. As always, tax planning is complex; professional tax advice from a Chartered Professional Accountant (CPA) should be sought before attempting to implement any tax-reduction strategy.
For the majority of Canadians, Tax Free Savings Accounts (TFSA) and Registered Retirement Savings Plans (RRSP) are like gifts from the government. They let us reduce our current taxable income (via RRSPs) and our future income (via TFSAs). In this regard, the high-income earner in a couple should contribute to their RRSP or a spousal RRSP (see Strategy #2 below), and a TFSA to ensure these valuable accounts are maximized.
Why this works
Drawbacks
A spousal RRSP can be a useful retirement planning tool. It is owned by the spouse with the lower income, but contributions are made by the higher-earning spouse who has earned more RRSP contribution room. In this strategy, the RRSP contribution limit is determined by the higher-income earner’s RRSP contribution room, and is not affected by the lower-income spouse’s contribution limit. The higher-income spouse will get the tax deduction in the year of contribution but, importantly, when money is withdrawn it is taxed via the lower-income spouse (within certain constraints outlined below under “Complex withdrawal rules”).
Why this works
Drawbacks
In this simple strategy, after TFSA and RRSP accounts are maximized, the lower-earning spouse saves and invests as much of their after-tax income as possible in a taxable non-registered account. Because their income falls within a lower tax bracket, less tax is owed on the investment income earned and the couple’s total nest egg will grow faster.
Why this works
Drawbacks
Although spouses cannot gift investment assets to each other without triggering attribution, CRA recognizes that any individual can apply for an investment or commercial loan. As a result, CRA has set clear rules that enable spouses to loan to each other provided interest is paid at a minimum rate, known as the prescribed rate. CRA announces the rate for Prescribed Rate Loans (in this case known widely as a Spousal Loan) quarterly, with the rate based on short-term government T-Bills. As of July 2020, the rate has fallen from a low rate of 2% to just 1%. Accordingly, when the high earner loans assets to their spouse, their income increases by the prescribed rate of just 1%. The lower-earning spouse can then invest the loan assets into investments with an expected return higher than 1%, thereby increasing the family’s investment income but at the lower-earning spouse’s tax rate.
Why this works
Drawbacks
While retired Canadians can also take advantage of many of the strategies outlined in previous sections of this document, there are some additional strategies that can be applied to their situation. Strategies #5, #6 and #7 outline these additional options.
In terms of strategies for Canadians entering retirement, retirees can use pension income splitting to give their spouse or common law partner up to 50% of their eligible pension income. To split pension income, certain criteria must be met:
Splitting pension income prior to age 65
If the transferring spouse is between the age of 55 and 64, only Registered Pension Plans such as defined benefit (DB) or defined contribution (DC) pension plans are allowed to income split 3 Examples of DB pension plans include employer pensions like those offered by the Government of Canada, as well as Individual Pension Plans (see Strategy #7 below).
Splitting pension income after age 65
As a result of rules issued by the Government of Canada in 2007, when the transferring spouse is over 65, it is possible to split Registered Retirement Income Funds (i.e. a RRIF withdrawal). The receiving spouse does not need to be over 65. If both spouses have eligible income, a decision will need to be made on who will act as the transferring spouse. Typically, this will be the spouse with the higher income. Once that is decided, form T1032 — Joint Election to Split Pension Income — can be filed.
Interestingly, Canada Pension Plan (CPP) and Old Age Security (OAS) payments do not qualify as pension income and, therefore, cannot be split. However, CPP does have an application process that enables “sharing” between spouses. Spouses or common-law partners may complete the pension sharing form (ISP1002) and mail it with supporting documents (marriage certificate or proof commonlaw relationship) to Service Canada as a request to share their CPP.
In order to share CPP, both spouses must be over the age of 60 and collecting CPP. The split for sharing is determined based on how long the couple has been together while receiving CPP. While the split can be 50/50, this may not be the case for a couple who met later in life.
Colloquially referred to as an “RRSP on steroids”, Individual Pension Plans (IPP) have been out of favour in low-tax jurisdictions in the past. However, with increased tax rates in recent years, IPPs have made a comeback.
Under pension legislation, corporations can set up individual pension plans for connected individuals (i.e. the owners of the business). In this way, business owners can create for themselves the benefits (and drawbacks) commonly associated with DB pension plans that may be provided by large corporations and governments.
Why this works
While retired Canadians can also take advantage of many of the strategies outlined in previous sections of this document, there are some additional strategies that can be applied to their situation. Strategies #5, #6 and #7 outline these additional options.
In terms of strategies for Canadians entering retirement, retirees can use pension income splitting to give their spouse or common law partner up to 50% of their eligible pension income. To split pension income, certain criteria must be met:
Splitting pension income prior to age 65
If the transferring spouse is between the age of 55 and 64, only Registered Pension Plans such as defined benefit (DB) or defined contribution (DC) pension plans are allowed to income split 3 Examples of DB pension plans include employer pensions like those offered by the Government of Canada, as well as Individual Pension Plans (see Strategy #7 below).
Splitting pension income after age 65
As a result of rules issued by the Government of Canada in 2007, when the transferring spouse is over 65, it is possible to split Registered Retirement Income Funds (i.e. a RRIF withdrawal). The receiving spouse does not need to be over 65. If both spouses have eligible income, a decision will need to be made on who will act as the transferring spouse. Typically, this will be the spouse with the higher income. Once that is decided, form T1032 — Joint Election to Split Pension Income — can be filed.
Interestingly, Canada Pension Plan (CPP) and Old Age Security (OAS) payments do not qualify as pension income and, therefore, cannot be split. However, CPP does have an application process that enables “sharing” between spouses. Spouses or common-law partners may complete the pension sharing form (ISP1002) and mail it with supporting documents (marriage certificate or proof commonlaw relationship) to Service Canada as a request to share their CPP.
In order to share CPP, both spouses must be over the age of 60 and collecting CPP. The split for sharing is determined based on how long the couple has been together while receiving CPP. While the split can be 50/50, this may not be the case for a couple who met later in life.
Colloquially referred to as an “RRSP on steroids”, Individual Pension Plans (IPP) have been out of favour in low-tax jurisdictions in the past. However, with increased tax rates in recent years, IPPs have made a comeback.
Under pension legislation, corporations can set up individual pension plans for connected individuals (i.e. the owners of the business). In this way, business owners can create for themselves the benefits (and drawbacks) commonly associated with DB pension plans that may be provided by large corporations and governments.
Why this works
Drawbacks
With these strategies, we feel that it is possible for Canadians to reduce taxes via effective tax planning. That being said, we have not addressed perhaps the most important question: why should we minimize our taxes?
Whatever our view of governments, they provide integral and necessary services to each of us as individuals within our society. However, reducing our families’ tax burden puts more money in our pockets and enables greater or faster fulfillment of our family goals. As a result, tax-reduction planning is only the first half of the financial equation that Canadian families should be considering; what we do with these savings is just as important. If you have questions about these strategies, please get in touch. We can integrate effective investment tax planning with financial planning, and ensure that your family’s goals are achieved as efficiently as possible.