Learn how testamentary spousal trusts provide income for your spouse, protect family wealth, and offer key tax benefits in estate planning
In recent years, the Canada Revenue Agency (CRA) has tightened the rules to close off loopholes and prevent taxpayers from engaging in aggressive income-splitting strategies. Income splitting—the practice of shifting income from a high-income earner to a lower-income family member—has been heavily scrutinized by the CRA. With the introduction of new rules such as the Tax on Split Income (TOSI) and changes to the Alternative Minimum Tax (AMT), many once-popular strategies have been curtailed.
However, within the framework of the Income Tax Act, there remain numerous legitimate ways to reduce the overall family tax burden. These opportunities enable families to allocate income more efficiently and, in doing so, mitigate the impact of Canada’s progressive tax system. In this post, we’ll explore several effective strategies to split income legally, providing you with practical insights into how to make the most of these opportunities.
1. Spousal RRSPs: Deferred Income Shifting
A Spousal RRSP is a powerful tool for income splitting between spouses. By allowing a higher-income spouse to contribute to their partner’s RRSP, the immediate tax burden is reduced for the contributor. Later in retirement, the lower-income spouse withdraws funds from the RRSP, and these withdrawals are taxed at their lower marginal rate.
- Benefit: Immediate tax deduction for the contributor, and future tax savings when the lower-income spouse withdraws the funds.
- Tip: Plan withdrawals carefully to avoid triggering the three-year attribution rule, which could result in the income being taxed back to the contributor.
2. Pension Income Splitting: Minimizing Retirement Taxes
For those over the age of 65, pension income splitting allows couples to split up to 50% of eligible pension income. This strategy is particularly useful for couples with one high-income spouse and one lower-income spouse. By shifting pension income, the couple can reduce their collective tax burden in retirement.
- Benefit: Reduces the marginal tax rate of the higher-income spouse while maximizing the lower-income spouse’s unused tax credits.
- Tip: This strategy works well with income from RRIFs, annuities, and other eligible pension sources.
3. Prescribed Rate Loans: A Creative Income-Splitting Strategy
Using prescribed rate loans is one of the more sophisticated ways to split income. In this scenario, the higher-income spouse lends funds to the lower-income spouse (or a family trust) at the CRA’s prescribed interest rate. The lower-income spouse then invests the money and pays tax on any income earned at their own (lower) rate.
- Benefit: Tax savings on investment income that is otherwise attributable to the higher-income spouse.
- Tip: Ensure that interest on the loan is paid by January 30th each year to avoid triggering attribution rules.
4. Canada Child Benefit (CCB): Building a Future Through Tax-Free Savings
The Canada Child Benefit (CCB) is a tax-free benefit that parents receive based on their family income. While the CRA limits certain income-splitting opportunities with minors, investing the CCB for your child’s future can still offer significant financial benefits.
- Benefit: Although any income from CCB investments is attributed back to the parent, the tax-free CCB itself can grow over time.
- Tip: Consider contributing CCB funds to a Registered Education Savings Plan (RESP) to maximize the long-term growth potential.
5. Registered Education Savings Plan (RESP): Tax-Deferred Education Savings
RESPs are one of the best ways to shift income to children. Contributions grow tax-deferred, and when the funds are withdrawn for educational expenses, they are taxed in the child’s hands. Since students typically have little to no income, they pay minimal tax on these withdrawals.
- Benefit: Tax-free growth and lower taxes upon withdrawal, plus government grants to boost savings.
- Tip: The Canada Education Savings Grant (CESG) matches 20% of your contributions, up to $500 per year.
6. Registered Disability Savings Plan (RDSP): Tax-Deferred Growth for Disabled Individuals
If you or a family member qualifies for the RDSP, it offers an excellent way to split income by deferring taxes until funds are withdrawn. Similar to the RESP, RDSP contributions grow tax-free, and withdrawals are taxed in the hands of the disabled individual, often resulting in little to no tax.
- Benefit: Significant tax savings and government matching contributions through the Canada Disability Savings Grant (CDSG).
- Tip: Plan RDSP withdrawals strategically to minimize taxes and maximize government grants.
7. Income Attribution Exceptions: Navigating the Rules
Attribution rules are designed to prevent improper income shifting between family members, but there are key exceptions that allow income splitting under certain conditions:
- Capital Gains: Capital gains from property gifted to a spouse may avoid attribution, unlike other forms of income.
- Salary to a Spouse: If one spouse operates a business, they can pay their spouse a reasonable salary, avoiding attribution on those earnings.
- Benefit: Allows you to shift certain types of income or capital gains legally to lower-income family members.
- Tip: Ensure the salary paid is reasonable for the work performed to comply with CRA guidelines.
8. Tax-Free Savings Accounts (TFSA): Split Income Without Attribution
TFSAs offer one of the most flexible and tax-efficient ways to split income. Contributions made to a spouse’s or child’s TFSA do not trigger attribution, and all growth within the account is completely tax-free. This makes TFSAs ideal for long-term tax-free growth and income splitting.
- Benefit: Tax-free growth and withdrawals, with no attribution on contributions made on behalf of a spouse or child.
- Tip: Take advantage of the ability to recontribute any withdrawn funds in future years, preserving your TFSA room.
9. Gifting to Adult Children: Transferring Wealth Tax-Free
Parents can gift assets to adult children (aged 18 or older), effectively transferring future income to a lower-taxed individual. This strategy shifts the tax burden from the parent to the child, allowing future investment income to be taxed at the child’s lower tax rate.
- Benefit: Moves future income and capital gains out of the higher-income parent’s hands and into the lower-taxed child’s.
- Tip: Be aware of family dynamics when gifting assets, as you may lose control over the property once it’s transferred.
10. Life Insurance: A Tax-Sheltered Wealth Transfer Tool
Permanent life insurance policies, particularly corporately owned ones, offer tax-sheltered growth and can be an effective income-splitting tool for high-net-worth individuals. The cash value of a policy grows tax-free, and the death benefit is paid out tax-free, providing liquidity for estate planning and wealth transfer.
- Benefit: Provides a tax-efficient way to pass on wealth, bypass probate, and shelter income from taxes.
- Tip: Consider corporate-owned life insurance for even greater tax advantages, especially for business owners.
Conclusion
While the CRA has introduced numerous rules to curb aggressive income-splitting tactics, many legitimate and effective strategies remain available under the Income Tax Act. From spousal RRSPs to prescribed rate loans and life insurance, these methods can provide significant tax savings when properly implemented. By understanding the available options and working with a qualified financial advisor, you can optimize your family’s tax position and reduce the overall tax burden for years to come.
If you’re looking to explore any of these strategies in more detail, consider reaching out to a financial professional who can tailor a plan specific to your needs.
Ready to secure your future and protect your loved ones? Book a time to sit down with us and start your estate planning journey today! Visit our calendar to schedule your consultation. We look forward to helping you achieve peace of mind.
