How To Use Income Splitting to Lower Taxes

No one likes paying high taxes, especially not when their careers advance. Sometimes, higher incomes mean higher taxes, but did you know there is a legal way of lowering tax bills called income splitting?

The tax on a split income is lower than it is when all your earnings are counted together. Read on to learn about these strategies and how much money they could save you on taxes.

What Is Split Income? 

Income splitting transfers income between family members (spouses, most commonly). This strategy is most beneficial if the two spouses have a significant income disparity. Note that marriage partners in the same tax bracket won't benefit from income splitting.

The higher-earning spouse transfers part of their income to the lower-earning spouse to take advantage of their lower income tax bracket. That way, the overall family tax burden becomes lower.

Although the Income Tax Act has attribution rules preventing income splitting, allowing the Canada Revenue Agency (CRA, which administers tax laws) to collect more considerable taxes, some exceptions exist. Let's see what those are and how they can work in your favour.

Canada Income Splitting Strategies

Income splitting strategies in Canada for lowering taxes are the following:

• A spousal loan
• A split pension income
• Tax-free savings accounts
• A spousal registered retirement savings plan

Spousal Loans

A spousal loan can be a great way to decrease the tax you pay on your income. By lending money to your lower-income spouse, you can help them invest in a business or property without incurring the high taxes that would be charged if they earned the income themselves. The CRA prescribed interest rate for spousal loans has been 1% since July 2020.

The interest on the loan must be paid to the lender every year by January 30. And the higher-income earner has to pay income tax on the interest from the loan. However, the reduction in taxes paid on investment growth usually outweighs the income tax paid on the loan's interest.

Here's how this type of income splitting in Canada works:

Spousal Loan Steps

1. You give a loan to your lower-income spouse.
2. Your spouse invests the funds.
3. Dividends are taxed at the lower-income spouse's tax bracket.

When you resort to this option, keep in mind the following:

• The loan must be interest-bearing.
• The interest matches the CRA’s prescribed rate, which is 1% at present.
• If your spouse fails to pay the interest by January 30 of the following year, the authorities will tax you at a higher rate by attributing it back to you.

If you expect an investment to generate returns higher than the interest rate required on a loan, this can be an excellent way to reduce your taxable income. If your spouse wishes to compare their loan options first, check out the types of loans available to Canadians.

Pension Income Splitting

You can use the split pension income to lower your taxes if you're a retired senior citizen (65+ years). Under this rule, you can allocate up to 50% of your eligible income to your spouse or common-law partner. That way, you can both benefit from lower tax rates.

Your eligible pension income includes:

• A lifetime annuity
• A company pension plan
• Registered Retirement Saving Plan (RRSP)
• Registered Retirement Income Fund (RRIF)

By completing the Joint Election to Split Pension Income form, a higher-income spouse can deduct some of their pension income and transfer it to the spouse who’s in a lower tax bracket.

What Isn't Eligible Pension Income?

Some types of pension income aren’t subject to tax on split income, such as:

• Death benefits
• Retiring allowances
• Old Age Security (OAS) benefits
• Canada Pension Plan (CPP) benefits
• Certain income reported on the T4RSP slips
• Excess funds transferred from one RRIF to another, an RRSP, or annuity
• Funds distributed from a retirement compensation arrangement on the T4A-RCA slip

Registered Retirement Income Fund

Here's how to split your income with your spouse in Canada if you have an RRIF.

First, you need to estimate your expected retirement income. If one spouse has a significantly lower retirement income, the higher-income spouse can contribute to their registered retirement saving plan (RRSP). This helps them save for retirement while enjoying a tax deduction.

Note that this strategy reduces the amount the contributor can pay to their RRIF. For example, if they pay $15,000 out of a maximum of $20,000 to their pension fund, they could contribute no more than $5,000 to their spouse's fund.

But, how does this income splitting type work in Canada? Let’s elaborate:

Steps

1. Lower-income spouses open a spousal RRSP account to split income and lower taxes; this account is separate from their RRSP account.
2. The funds in the spousal RRSP are tax-sheltered; when the funds are turned into an annuity or RRIF, the payments become income to the spouse.
3. When the spouse withdraws the money in retirement, they'll pay tax on the withdrawals at a lower rate.

Ensure you don't exceed your RRSP contribution limit, as that will prevent you from contributing to a spousal RRSP. Also, note that premature withdrawals (less than three years from the time of contribution) incur tax on the contributing partner.

Tax-Free Savings Account

Different income splitting rules in Canada apply to a Tax-Free Savings Account (TFSA). It’s a savings account where you don't pay taxes on the money you earn. You can contribute up to $6,000 in cash annually since 2021, and the money you withdraw is tax-free. Moreover, owners of this account can withdraw funds anytime, which offers way more flexibility than an RRIF.

Contributing to a spouse's TFSA is a great way to lower your overall tax bill. Any such contribution is considered "after-tax" money, so no attribution rule is in effect. That means you can contribute up to the maximum amount for yourself and your spouse without worrying about income taxes or potential penalties.

Tax Return on Spousal Income Split: An Example

Let's say one spouse’s annual salary is $150,000 (far above the average income in Canada in 2024), while the other partner is a stay-at-home parent. If they don't split the funds, taxes on this amount would be the following:

But, if they split the amount in the 2:1 ratio, the taxable income between spouses remains the same, but the taxes become lower:

So, sharing total funds between family members can reduce the tax bill on the household considerably. And in this case, different tax brackets make a difference of $13,600.

Other Exceptions to Tax Act Attribution Rules

Now that we have explained how income splitting works, let's point out another tax exemption in the Income Tax Act.

It involves paying dividends to your spouse and children from an incorporated business or rental property. You can make them shareholders if your business is a corporation (they don't need to be company employees in this capacity).

Note that you don't have to make them shareholders at the inception stage since you can add them throughout the year. Once you do, you reduce tax payments through dividends distributed to the family.

Conclusion

You can split your income and lower your taxes by contributing to a spouse's TFSA, opening a spousal RRSP, or resorting to other solutions we mentioned. Always stay within the contribution limits and keep track of the attribution rules to avoid over-extending.