How Income Splitting Works
Income splitting is a great way to reduce your tax bill. It allows you to move income from a higher-income spouse to a lower-income spouse, to take advantage of lower tax rates. But how does it work? Let's take a look.
What does income splitting mean?
Income splitting in Canada is a method by which the higher-income spouse (aka higher-earning spouse) transfers a part of their income to the lower-income spouse (aka lower-earning spouse). An income splitting strategy is used so that both taxpayers end up with similar taxable income.
Ideally, each spouse should end up in the same tax bracket, thereby lowering the household's overall tax bracket and resulting taxes payable. Only eligible pension income is allowed to split using income splitting. You can split eligible pension income with your spouse or common-law partner, up to 50%.
Although income splitting can be implemented before retirement, it is less common.
What can be done relatively easier and early on, however, is making use of a spousal RRSP. Since the higher income spouse will be able to put aside more money into savings, they can contribute some of it to a spousal RRSP.
In this way, you can make sure that the RRSPs of both spouses will be similar in size at the time of retirement. This will result in a lower overall tax burden, as income withdrawals from two smaller RRSPs will result in less taxable income than withdrawals from a single large RRSP.
The more common income splitting scenario takes place during retirement, when spouses will split pension income.
Advantages of income splitting
Income splitting can be beneficial for any couple where one spouse has significantly higher income. But, income splitting is most advantageous for high-income earning couples that are normally in high tax brackets. When you are retired, you will no longer have employment income.
However, your investment accounts will hopefully be supplying you with income. If the investment income earned from your investment accounts is big, your resulting tax bracket will be high. This is when income splitting comes into play.
Simply put, if you are retired and you end up in a different income tax bracket than your souse, you should investigate income splitting to lower your overall tax liability.
An example of income splitting
Jane and John Doe are a retired married couple. Jane's pension income and investments are significantly larger than John's, especially the interest income that she earns on her investments. As a result, John is in a significantly lower income tax bracket.
In this example, Jane is the transferring spouse and John is the receiving spouse. Therefore, splitting pension income will reduce the combined tax obligations of the couple, allowing them to each fall under the same tax bracket and reduce taxes.
Types of income eligible for income splitting
Unfortunately, not all kinds of income are eligible for income splitting. There are also limitations on the type of taxpayer. Specifically, the spouse (or common-law partner) receiving the pension needs to be at least 65 years of age (there are a few exceptions to this rule, see CRA's guide for more details: Line 31400 - Pension income amount).
For this tax reduction strategy, both spouses must also live in Canada and live together during the tax year of the income splitting. Certain exceptions apply, for example if one spouse is separated for medical reasons. But, generally, you must be living together and living in Canada.
Assuming both taxpayers qualify for income splitting, here are the eligible types of income:
Income from a RRIF (Registered Retirement Income Fund), except amounts included on line 11500 and transferred to an RRSP, another RRIF or an annuity
RRSP (Registered Retirement Savings Plan) annuity payments
Life annuity income
The following types of income are NOT eligible for income splitting:
Government benefits, such as Old Age Security (OAS) payments
Income from the Canada Pension Plan
Income from the Quebec Pension Plan
Income from a United States individual retirement account (IRA)
Check the following resource for more details about the eligibility of certain types of income: CRA - Eligible pension income.
How to income split
You must opt-in to income splitting every year when you have your tax return prepared. Both spouses will need to file Canada Revenue Agency Form T1032, Joint Election to Split Pension Income. Don't worry if the T1032 form looks complicated; a qualified professional accountant can help you complete it accurately and make sure that you comply with the income tax act.
Frequently Asked Questions
Let's review the questions that often arise when researching financial planning and how to lower the tax burden through pension income splitting:
What is income splitting?
Income splitting is a plan that allows retirees (in different tax brackets) to transfer pension income to the lower income spouse (up to 50%) to take advantage of a lower tax bracket. To use income splitting, certain conditions must be met regarding the type of taxpayers, as well as the types of income.
What is the benefit of income splitting?
All things considered, you would rather pay tax on your income in a lower tax bracket. Using income splitting, you can transfer pension income (such as from a registered retirement income fund) to your lower income spouse and reduce the overall tax liability of your household.
Who is allowed to split income in Canada?
Generally, both spouses must live together and live in Canada during the specified tax year. There are some exceptions, however.
What qualifies for income splitting?
Eligible income types include income derived from registered retirement income funds (RRIF) and registered retirement savings plan income.
If it is time to file your taxes and you are looking for high-quality help, consider using Blackspark. Our professional tax accountants are experienced in all tax matters and will help you realize the maximum benefit from your tax situation.
This blog post is intended to provide general information only and should not be construed as tax advice or opinions. Always consult a professional accountant for specific advice related to your situation. Thank you.
