Last week's post noted five ways any investor can use to legitimately minimize taxes. This week, let's look at strategies specific to couples and families.
All strategies involve income splitting - The objective is to equalize taxable income within a family to lower total taxes, since paying a combination of middle range tax rates means paying less tax than a low-rate or a nil-rate and a high-rate together. Canadian Tax Resource blog provides a short primer in What is Income Splitting?
1. Loan to Spouse/Child at CRA Prescribed Rate - When a high income (and thus high tax rate) earner loans his/her family member money to invest, the gains or income on the investments will get taxed in the hands, and at the lower rate of, the family member. Result: the couple overall will pay less taxes. CRA specifies here the Prescribed Rates on a quarterly basis that allow this to be legitimate. Use the rate labeled " taxable benefits for employees and shareholders from interest-free and low-interest loans". Income Splitting at TaxTips.ca describes more rules on how to do this properly and works through an example. The current rate of 1% is as low as it ever can be (since it must be a positive whole number). Now that talk is turning to when interest rates will rise, the absolute ideal time to implement the loan strategy may be soon. If interest rates rise there is a quarterly lag between when rates have risen and when CRA changes the Prescribed Rate e.g. the 1% rate in effect now is valid at least till June 30th. Meanwhile, the 1% rate is locked in for the life of the loan. That loan becomes increasingly attractive as rates rise and as income and tax savings received by the lower income person compound. The high earner reports as income on his/her tax return the 1% interest received while the low earner can claim the interest as a deduction. A final advantage of the minuscule 1% rate is that since the rules dictate that the interest must actually be paid, the amount will still be small even with a substantial loan (e.g. 1% of $100,000 is only $1,000 interest).
2. Contribute to Spouse's TFSA - The high income spouse, having used up his/her own $5000 annual contribution room, puts money into the TFSA of the low income person. There is no attribution of income back to the high income spouse and the amount grows tax-free.
3. Contribute to Spouse's RRSP - Using the high income earner's own contribution room, income from amounts put into the spouse's RRSP will not be taxed back in the high earner's hands if not withdrawn in the year of contribution or in the prior two years.
4. High Income Spouse Pays Bills (including even income tax payments) with non-deductible cash while the low income spouse invests to earn income that will be taxed at a a lower rate. A variation on this method is for the low income spouse to take out an investment loan from an arm's length third party, e.g. a bank, while the high income spouse pays the interest on the loan. The low income spouse still gets to deduct the interest as an investment expense while all the income is taxed in his/her hands and not in those of the high earner.
5. Transfer Very Low Income Spouse's Dividends to High Earner - If a person has such low income that there is no tax to pay, the dividend tax credit, which is only applicable against tax owing, may not be usable. Combined with the fact that any income (such as dividends) the low income spouse earns reduces the spousal credit amount dollar for dollar, it can be advantageous, and is permitted, for the high income taxpayer to report the dividends received by the low earner on his/her return. KPMG's book Tax Planning 2010 suggests doing the calculation both ways to see what gives off the lowest tax to pay. Should my spouse and I file our tax returns together or separately? on TaxTips.ca gives helpful explanation. Some of the tax preparation software packages automatically figure out the best way if both spousal returns are done with the same package.
Disclaimer: this post is my opinion only and should not be construed as investment or tax advice. Readers should be aware that the above are food for thought and are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Some strategies are more complicated and will not work if not carried out precisely in keeping with the tax rules. Do your homework before making any decisions and consider consulting a professional advisor.