Tuesday, 7 February 2012

Save Tax by Income Splitting with RRSP, TFSA, Loans and Pension Income

Canada has a progressive income tax system whereby the higher your income the greater the percent tax you must pay. The range of rates goes from zero for very low income up to 50% for the highest earners in the most-taxed province of Nova Scotia. TaxTips.ca maintains a handy webpage with current (2012) tax rates in all the provinces and territories that show the breakpoint amounts for the eight or so steps in the tax ladder.

What is Income Splitting?
Spouses (or common-law partners) can lower their overall combined tax bill by shifting income from the high-income high-tax person to the low-income low-tax person, i.e. evening out, or splitting, income between the two people. For example, if $150,000 in earnings taxed at 43.7% in BC could be split $75,000 between two people and taxed at 32.5% there would be a tax savings of $16,800. The bigger the tax bracket difference, the more worthwhile the technique. However, the taxman doesn't want to be too generous and there are many restrictions by the Canada Revenue Agency (CRA) on income splitting. Here are some permissible ways to accomplish splitting.

1) Contribute to the low-income person's Spousal RRSP
Using his/her own RRSP contribution room, the high income spouse contributes to the other person's RRSP. The contributor gets to claim the tax refund, i.e. saving taxes at the higher tax rate. When the spouse eventually withdraws the funds it will be at his/her lower rate. The difference in contribution vs withdrawal tax rates can create a large saving. To see how beneficial this can be, consider the simple example below, where we take an Ontario couple at opposite ends of the income scale - one at the highest rate 46.41% and the other at the bottom rung of 20.05% (figures from TaxTips). There is an impressive tax savings of almost $5300 on a withdrawal of $20,000. That's even before considering the potential tax-free gains of the investments within the RRSP, which is the primary purpose of RRSPs and a great benefit in itself.

An important caveat: the recipient spouse must not withdraw the funds during the year of contribution nor the following two calendar years, otherwise the CRA simply taxes the amount in the hands of the contributor.

Note that the Spousal RRSP method's advantage lies mainly for withdrawals before age 65 since after retirement (age 65+) the next strategy we describe allows RRSP-derived income to be split. However, the Spousal RRSP is still useful after retirement since it effectively allows all of the retirement income for that contribution to be transferred to the low income spouse. This can be useful to reduce total family taxes if, for example, the high income spouse has non-registered investments that cannot be split. In that case it is advantageous for the low income spouse to keep all or more of the Spousal RRSP withdrawal for taxation in his/her hands.

2) Split eligible pension income
A person 65 or over is allowed to transfer up to half of something called eligible pension income to a spouse. If the older person has higher income, this enables amounts to be taxed at the lower bracket person's rate and saves tax overall. The recipient spouse need not be over 65. No actual cash needs to move from one spouse to the other, the adjusted income amounts are simply declared on the tax returns of the couple and CRA form T1032 to fill in. As BMO Nesbitt Burns suggests in its pamphlet on pension income splitting, there may be also be a benefit for the higher income spouse through preventing OAS clawback.

Eligible pension income is a strictly defined term and includes withdrawals from a RRIF (when the person withdrawing is at least 65
) but not from an RRSP i.e. the RRSP would have to be converted to a RRIF. See TaxTips.ca for further detail on the general criteria for pension income splitting and on what qualifies as eligible pension income. The official CRA info on pension income splitting is here. Readers may also find helpful interpretation of their own situation or questions from the Ask-Fred page of the financial advisor firm Canada Retirement Information Centre Inc.

Converting at least some of an RSSP to a RRIF (it isn't necessary to convert all of an RRSP at once and it is possible to have both RRSPs and RRIFs in existence at the same time) for those 65 gives the opportunity to use the pension income tax credit. The tax credit eliminates tax in the lowest tax bracket, or substantially reduces it in higher brackets, on the first $2000 of eligible pension income. When both spouses are over 65, the possibility to split income and to use the credit for both people, or to transfer unused portions from one person to the other, can save more in taxes.

3) Split CPP income
Though CPP is specifically excluded from the list of types of eligible pension income mentioned in the previous strategy (because the CRA wants it not to count when figuring out the pension income tax credit), it is possible to split CPP, or share it, as the government puts it on the Service Canada Sharing your retirement pension page where the details of how it works are explained. Read the rules carefully, since not all of the CPP may be eligible for sharing if you did not live together the whole time CPP contributions were being made. Blue Chip Advice has an excellent chart that neatly shows the combined effect of CPP and pension splitting for an Ontario couple.

4) Contribute to spouse's TFSA

If your own TFSA and RRSP contribution room has been used up, then putting money into a spousal TFSA places savings into an account where tax-free growth can occur. There is no tax deduction as for an RRSP of course, but the alternative of investing the funds in a regular taxable account is less advantageous (see our previous post comparing investing through an RRSP or a TFSA versus a non-registered taxable account. And, the spousal TFSA contribution avoids the income being attributed back, and taxed back, in the hands of the high income spouse, which would happen if the funds went into a non-registered taxable account, whether in the name of the low income spouse or not.

5) Loan money to spouse for making investments
If the high income spouse loans money to the low income spouse, the gains or income will be taxed in the latter's hands. The loan must meet certain conditions for CRA to consider it legitimate and not simply tax the high income donor, such as: a) documenting this arrangement with a written loan agreement like a promissory note that specifies principal amount and interest rate on the loan, b) actually paying the interest no later than January 30th each following year and c) charging interest at least equal to the rate prescribed by the CRA (the one labelled "for employees and shareholders from interest-free and low-interest loans") The prescribed rate at the moment is only 1%! That rate can be locked in for the life of the loan even though the prescribed rate later goes up - at some point it will rise since today's record low interest rates cannot remain so forever. One drawback pointed out by TaxTips is that savings are modest unless the loan is substantial. An inheritance received by the high income spouse is one example where this strategy could be applied. One method that does NOT work is for the high income spouse to give the money to the low income spouse. Under CRA's attribution rules, the CRA would deny the low income spouse's attempt to claim any income from the inheritance/gift as his/her own and would tax it as income of the high income spouse.

6) High earner pays household expenses, low earner invests
Whether it is groceries, mortgage payments, credit card bills, car payments, even income tax owing by the low earner, when the high bracket person pays such expenses the low earner can invest and all the income gets taxed only in the low earner's hands. The high bracket spouse can even pay the interest portion, but not the principal, of a third party loan for investment taken out by the low earner. The interest payment must have a clear paper trail to the high earner only, like a personal cheque. A separate account could certainly help.

7) Transfer dividends to the high income spouse
This counter-intuitive tactic can help when the low income spouse has such low taxable income that no tax would be payable and the dividend tax credit might go unused. To be allowed to do this the high income spouse must thereby be able to claim a larger spousal tax credit. Even when such a transfer is possible, there may not be a net benefit. The only way is to do the calculation both ways. This caveat brings up the next point.

Run the numbers and consider getting advice before proceeding
Due to the complexity of our tax system, many of the techniques above can seem to have the effect of that famous arcade game Whack-a-Mole (see YouTube video of someone very good at it). No sooner do you push down taxes with one tactic but it has the effect of raising income or reducing deductions that push taxes back up elsewhere. While generally working as described, individual circumstances of couples might not result in much or any tax reduction.

One convenient way to try things out is with the best of the tax preparation packages. The best packages don't just transcribe your data entries onto the correct lines, they try to figure out what combination of claims, transfers and deductions will give the lowest tax (see CanadianFinancialDIY's review of the packages last year; this year's review is not yet out). Both spousal returns must be done simultaneously in the same package of course. In the online web versions of the packages, you can enter all the data and see the net results before paying (though you must pay before getting filable or printable format data). Another tool to do what if scenarios is TaxTips's quite detailed Canadian Income Tax Calculator.

The other way to be sure of your step in carrying out these strategies is the ever-wise consultation with a professional, a tax accountant in this case.

Spousal equality is a social and personal ideal pursued by many. Spousal equality of taxable income certainly pays off in lower taxes.

Disclaimer: this post is my opinion only and should not be construed as investment or tax advice. Readers should be aware that the above comparisons are not an investment or tax recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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