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.

The impact of progressive tax rates

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.

Table A: Highest level of combined taxation by province in 2020 

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:

 

  • An Albertan earning $400,000
  • An Alberta couple earning $200,000 each
  • An Alberta couple with one spouse earning $340,000 and the other spouse earning $60,000

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.

Key background: CRA’s attribution rules

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.

Table B: Highest tax impacts due to different family income situations1

 

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. 

Strategies for working Canadians

Strategy #1: Maximize RRSPs and TFSAs

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

 

  • Lower lifetime taxes (If applicable): RRSPs reduce taxable income levels in the year of contribution enabling high-income Canadians to reduce their tax load. Assuming the high earner has a lower savings and capital in retirement compared to when they are working, this can be very valuable.
  • Tax-deferred growth: In addition, investment earnings inside of a RRSP account are not taxed until withdrawn, allowing them to grow faster than in a taxable account.
  • Tax-free growth: Money held in a TFSA can be withdrawn without tax, which enables money inside the account to grow tax-free into the future.
  • Higher earner contributions: TFSAs are one of the few financial products via which a high earner can gift money to a spouse and not have attribution rules apply. This is not the case for RRSPs; a spousal RRSP should be used instead (see Strategy #2 below).

Drawbacks

 

  • Taxes on withdrawal: RRSP assets are taxed when withdrawn from the account. If a Canadian has been a very successful saver and their retirement tax rate is higher than when they were working, this can create an unexpected tax burden in retirement.

Strategy #2: Spousal RRSP

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

 

  • Early retirement: While seniors in Canada can currently split Registered Retirement Income Fund (RRIF) withdrawals for tax purposes, this can happen only once the RRIF owner has turned 65. Spousal RRSPs can allow splitting prior to age 65 by enabling equal-sized account withdrawals and thereby placing spouses within equal income brackets. As we saw in our introductory example, two equal, taxable incomes are most tax-advantageous.
  • Age arbitrage: Most Canadians lose the ability to contribute to RRSPs once they turn 71 and have to convert their RRSP to a RRIF. However, if one spouse is younger, the older spouse can contribute to a spousal RRSP and reduce their taxable income via this contribution, even if they are over the age of 71 and drawing from a RRIF.

Drawbacks

 

  • Complex withdrawal rules: Funds must remain in the plan for at least two calendar years after the year of any contribution (i.e. as much as three calendar years), or they will be attributed back to the contributor and taxed in their hands.

Strategy #3: High earner spends, low earner invests

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

 

  • Simplicity: Relatively simple way to get more investment income into the hands of the spouse with the lower tax bracket.

Drawbacks

 

  • Communication: Requires some teamwork and consultation.
  • Patience: Can take a long time to accumulate large amounts in the lower-income spouse’s investment account.

Strategy #4: Spousal Ioan

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

 

  • Shifting income: Very quickly enables the movement of income or capital gains generating assets into the lower-earning spouse’s tax bracket.
  • Locking in the rate: Once the loan is set up, the prescribed rate is locked in. This makes a spousal loan at today’s historically low rate of 1% ideal. Even if interest rates rise in the future, the prescribed rate loan will not increase.
  • Deductibility: Interest paid to the lending spouse is potentially deductible by the borrower.

Drawbacks

 

  • Estate costs and complexity: 2 This is probably the most overlooked aspect of spousal loan implementation. It can create headaches for executors and potentially higher estate costs and reduced distributions for beneficiaries. An estate lawyer should be consulted to review and update estate plans whenever a spousal loan strategy is implemented, as many possible outcomes have to be considered. For example:
    • If the borrowing spouse dies, will the loan (now a testamentary debt) be repaid? Or will it be forgiven on death? Will loan forgiveness rules create potential income inclusion as outlined in Section 80(13) of the Income Tax Act, along with the resulting tax implications?
    • If the lending spouse dies, does the surviving spouse have the assets to pay back the loan? Does the estate trustee have the capability to work with the surviving spouse to organize this?
    • Are there more estate beneficiaries than just the lending spouse (for example, a child or sibling of the deceased), whereby the loan resolution process becomes even more complex?
  • Detailed paperwork: This income-splitting strategy must be treated as any other third-party loan:
    • A spousal loan agreement or promissory note must be signed.
    • An annual interest payment from the borrowing spouse must be paid to the lending spouse before January 31 of the following year.
    • Records of transactions should be kept to confirm with CRA the existence, details and compliance of the loan.
  • Accounting costs: While most CPAs are fully up to speed with the arrangements for spousal loans, additional tax reporting steps must be followed in order to add the interest income to the income of the loaning spouse, and deduct it from the income of the borrowing spouse. This may be difficult for Canadians who prepare their own taxes.
  • Citizenship: Both spouses should be Canadian citizens. Other citizenship status can create adverse tax effects.
  • Breakdown of the relationship: The separation or divorce process will also need to include resolution of the spousal loan agreement. Advice from a family lawyer should be obtained.
  • Family trusts: It may be advantageous to use prescribed rate loans within a family trust structure. As this adds another layer of complexity, professional tax, legal and estate advice should be sought.
  • Transitioning to a lower interest rate: The recent change of the prescribed rate from 2% to 1% makes this strategy very attractive. However, taking a loan previously put in place at the higher rate and transitioning to the new low rate may have pitfalls. For example: Does the higher rate loan have gains or losses? What will be the tax impact? In addition, the old loan must be paid back in full and a new loan agreement created. If the previous loan is not paid back and a new loan agreement developed, CRA may attribute the investment income from inception of the loan back to the lending spouse, thereby negating all income splitting benefits.

Strategies for retired Canadians

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.

 

Strategy #5: Splitting eligible pension income

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:

 

  • married or common-law
  • resident of Canada on December 31 of the tax year
  • the transferring spouse earns pension income

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.

 

Strategy #6: Applying for Canada pension plan sharing

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.

 

Strategy #7: Individual pension plan

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

 

  • Total contributions can be higher: As beneficiaries of a pension grow older, pension legislation allows a much higher rate of income to be contributed to the pension in comparison to RRSP contribution rates. For example, RRSP contributions are capped at 18% of earned income even at retirement ages like age 64. Individual pension plans, however, enable contributions to the plan of just over 29%.
  • Contributions are deductible to the business: As with all DB pension plans, the sponsoring company makes contributions on behalf of the individual. These contributions are deductible for the corporation, thereby reducing the tax owed by the company.
  • Deductible investment management fees: Unlike RRSPs, all investment management fees pertaining to a pension plan are deductible.
  • Income splitting: As IPPs are considered DB pension plans, withdrawals can be split between spouses for tax purposes as early as age 55. This is a significant benefit for successful business owners who plan to retire early.
  • Opportunity for additional tax-deductible contributions: Under pension legislation, DB pension plans are expected to provide returns of 7.5% per year. With today’s current extremely low interest rates, this is unlikely to happen. As a result, DB plans typically have a shortfall that must be resolved via additional contributions from the sponsoring corporation. While this is optional for IPPs where the beneficiary is a connected individual, contributions are tax-deductible to the business. As a result, a significant tax benefit can be created by moving assets from the business to an individual name via an IPP arrangement.
  • Creditor protection: Pensions are considered separate assets from the sponsoring corporation. Individual pension plans can therefore provide protections from creditors, provided the IPP was created prior to any potential creditor issues.
  • Intergenerational wealth transfer: Any employee who has been paid T4 income from the sponsoring corporation can be included within the individual pension plan. Spouses or children who have worked in the business thus may take part in the IPP. If the corporation (and IPP) is maintained after the death of the founders, assets within the IPP can provide for the surviving beneficiaries.

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.

 

Strategy #5: Splitting eligible pension income

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:

 

  • married or common-law
  • resident of Canada on December 31 of the tax year
  • the transferring spouse earns pension income

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.

 

Strategy #6: Applying for Canada pension plan sharing

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.

Strategy #7: Individual pension plan

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

 

  • Total contributions can be higher: As beneficiaries of a pension grow older, pension legislation allows a much higher rate of income to be contributed to the pension in comparison to RRSP contribution rates. For example, RRSP contributions are capped at 18% of earned income even at retirement ages like age 64. Individual pension plans, however, enable contributions to the plan of just over 29%.
  • Contributions are deductible to the business: As with all DB pension plans, the sponsoring company makes contributions on behalf of the individual. These contributions are deductible for the corporation, thereby reducing the tax owed by the company.
  • Deductible investment management fees: Unlike RRSPs, all investment management fees pertaining to a pension plan are deductible.
  • Income splitting: As IPPs are considered DB pension plans, withdrawals can be split between spouses for tax purposes as early as age 55. This is a significant benefit for successful business owners who plan to retire early.
  • Opportunity for additional tax-deductible contributions: Under pension legislation, DB pension plans are expected to provide returns of 7.5% per year. With today’s current extremely low interest rates, this is unlikely to happen. As a result, DB plans typically have a shortfall that must be resolved via additional contributions from the sponsoring corporation. While this is optional for IPPs where the beneficiary is a connected individual, contributions are tax-deductible to the business. As a result, a significant tax benefit can be created by moving assets from the business to an individual name via an IPP arrangement.
  • Creditor protection: Pensions are considered separate assets from the sponsoring corporation. Individual pension plans can therefore provide protections from creditors, provided the IPP was created prior to any potential creditor issues.
  • Intergenerational wealth transfer: Any employee who has been paid T4 income from the sponsoring corporation can be included within the individual pension plan. Spouses or children who have worked in the business thus may take part in the IPP. If the corporation (and IPP) is maintained after the death of the founders, assets within the IPP can provide for the surviving beneficiaries.

Drawbacks

 

  • Earned income requirement: In previous years, it was common for business owners to drive down their earned income, such as salary, and pay themselves via dividends instead. However, pension legislation requires the issuance of T4 tax slips in order to create both RRSP and IPP room. Not having T4 income in the past may remove the IPP option.
  • Age dependent: Because IPP contribution room increases with age, the benefits accrue as beneficiaries get older. As a result, IPPs are typically considered after the business owners are in their 40s.
  • Complexity: Pension legislation and requirements are cumbersome and complex. Adding an IPP to both an individual and their business’ financials requires ongoing management, time and effort.
  • Additional actuarial costs: Pensions require regular tax filings as well as actuarial analysis and reporting. This can lead to additional annual actuarial costs, typically in the $1,500 to $2,500 per year range.
  • Additional accounting costs: As tax reporting must align with the actuarial reporting requirements, additional accounting costs should be expected.
  • Withdrawal constraints: Pensions are designed to provide lifetime retirement income for the beneficiaries. As a result, while IPPs have some optionality when it comes to how beneficiaries can withdraw money from the pension plan, there is much less flexibility as to how much can be drawn in comparison to RRSPs or TFSAs.
  • Taxes on withdrawal: As with RRSP assets, IPPs are taxed when money is withdrawn. If a business owner has been a very assiduous saver or business-builder, this may create an unexpected tax burden in retirement.

Conclusion

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.

Marshall McAlister, CFA
Marshall McAlister, CFA
Private Wealth Counsellor
marshall.mcalister@mercer.com
Cary Williams, CFP, CIM
Cary Williams, CFP, CIM
Private Wealth Counsellor
cary.williams@mercer.com

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