Income Splitting and Attribution Rules
AN INTRODUCTION TO TAX PLANNING – PART 3
In a world where governments are scrambling to address the impact of the novel coronavirus on our society, the topic of this post may seem rather mundane or even unnecessary. However, there is applicability. Let’s assume a married couple: one spouse works in an essential service and is busier than ever; the other spouse works in a field deemed non-essential and is without work or income. While governments are responding in ways that should ease the financial burden to at least some degree, one effect is sure to be that some people will earn considerably less income in 2020 than they did in 2019. This may present a tax-saving opportunity.
Splitting Income with Your Children
Canada Child Benefit
The Canada Child Benefit (CCB) is a tax-free monthly payment made to eligible families to help with the costs of raising children. If you have sufficient income to manage your expenses without it, you may wish to consider depositing the CCB into an account for your child. While the benefit itself is tax-free, the income earned is not. It would instead be taxed in the hands of the child. As children generally do not have sufficient income to pay tax, the income from these deposits is effectively tax-free as well.
Registered Education Savings Plan
A Registered Education Savings Plan (RESP) is another way to save on taxes. You do not get a tax deduction for making contributions to an RESP, but the contributions grow tax-free while inside the plan and also attract the Canada Education Savings Grant (CESG). When funds are withdrawn for education, the portion that is taxable is referred to as an Education Assistance Payment (EAP). The EAP consists of the CESG and any of the growth in the account from interest, dividends or capital gains. This portion is taxed in the hands of the beneficiary student. Again, given that most students have minimal income, it is unlikely that much, if any, tax will be payable. When the non-taxable portion, the contributions, are withdrawn, this is known as a Post-Secondary Education Capital Withdrawal (PSE). As there was no tax deduction when it was contributed to the RESP, the contributed capital is not taxed when it is withdrawn.
Informal In-Trust Account
This can be an alternative, or a supplement, to an RESP. The benefit (and the risk!) here is that the money can be used for your children for other purposes than education. It is also the type of account in which you would deposit the Canada Child Benefit, but you may want to have a separate account for the CCB so as to avoid co-mingling these funds with “regular” money. If you open an account in-trust for your minor children, due to attribution rules, you will be responsible for tax on any dividend and interest income earned in the account until the minor reaches the age of majority. However, capital gains are taxable to the minor children.
A warning about informal in-trust accounts: Once the child reaches the age of majority, the money is no longer yours to manage. In fact, once deposited, the funds belong to the children. You manage them in-trust for your children. It belongs to your adult child and you have no right to interfere with how they use it. As these accounts are informal, they do not have the legal documentation of formal trusts. You cannot arrange for other terms to release the funds, nor can you arrange for contingencies like the death of the trustee or the beneficiary.
Splitting Income with Your Spouse
Spousal Registered Retirement Savings Plan
Although RRSPs can be used to assist with home purchases and furthering your education, they were created to encourage Canadians to save for retirement. If in the case of a married couple, one spouse has a considerably higher income than the other, in order to help equalize income and therefore taxation in retirement, the higher income spouse can contribute to the lower income spouse’s spousal RRSP. Why is this valuable? Contributions to an RRSP are generally tax deductible. Tax deductions are better for those in a higher income tax bracket. The table below illustrates the difference in tax savings for a lower income spouse with a 20 percent tax rate versus the higher income spouse with a 40 percent tax rate. The same $10,000 contribution to an RRSP results in a significant difference in tax savings.
To be clear, though, the contribution made by the higher income spouse to the spousal RRSP comes out of the higher income spouse’s contribution room. The income splitting, then, comes in the future, when both spouses are withdrawing from their accounts, whether for retirement or for other purposes. In fact, the government has established a rule that prevents short-term income splitting. Imagine you make a spousal contribution now, for the 2020 tax year and continue to do so annually through 2024. In 2024, your spouse withdraws all $25,000 in contributions. As the contributions were all made to the spousal RRSP, you assume that the withdrawal will be taxed at your spouse’s lower tax rate. Unfortunately, no. Withdrawals made in the year of contribution or the two subsequent calendar years are taxed in the contributing spouse’s hands. The following table illustrates:
What is the difference in taxation as a result? Let’s assume that the lower income spouse who received the contributions is still being taxed at 20 percent and the higher income contributing spouse at 40 percent. Let’s further assume that there were no more contributions made after 2024 and that the receiving spouse did not withdraw the $25,000 until 2027.
You can see in the table below that there is a tax savings of $3,000 by arranging to tax the withdrawal entirely in the lower income spouse’s hands versus leaving three out of the five years of contributions in the hands of the contributing spouse at the time of the withdrawal.
Funding a Tax-Free Savings Account
Attribution rules do not apply with respect to a TFSA as contributions are made with after-tax funds, and income is not taxed either within the TFSA or upon withdrawal. Nor do you need earned income in order to contribute to a TFSA, unlike with an RRSP. That means you can contribute to your spouse’s TFSA, or, if they are of age, to your children’s TFSAs as well, as long as you do so within the allowable contribution limits. See this blog post if you would like to learn more about TFSAs. Note that as of 2020, the accumulated contribution limit has risen to $69,500 if you have been continuously eligible since 2009. Although you don’t get a tax refund, if you earn a higher income than others in your household, this can be a great way to effectively split income and shelter it from tax.
Lending Money to Your Spouse at the Prescribed Interest Rate
Jane is a high earning partner at her law firm. Her husband John is a part-time freelance graphic designer. He works from home so that he can take care of their two children. In order to even up their income, Jane lends John $100,000 and charges him the prescribed interest of 2 percent as mandated by the Canada Revenue Agency. John invests the $100,000 loan and earns 6 percent or $6,000 in the course of the year. He is obligated to pay 2 percent, or $2,000, back to Jane. Jane reports the interest income to the CRA John reports the $6,000 in investment income that he earned and writes off the $2,000 in interest that he paid to Jane as an investment expense. This procedure has the effect of shifting some income to the lower income spouse, thereby reducing their overall tax bill.
This strategy only makes sense if there is a significant difference in income between the two spouses. It also requires careful documentation so a qualified tax professional should be consulted. Failing to properly document your actions could lead to all of the income being attributed back to the higher earning spouse.
The Higher Income Spouse Pays the Bills; The Lower Income Spouse Invests
Spouses organize their household expenses in a variety of ways. When it comes to household bills, couples may choose to contribute to those bills equally, or proportionate to their income. Matthew and Amanda are a very tax-conscious couple. They want to follow the rules, but they don’t want to pay more tax than necessary. Amanda makes $100,000 annually, while Matthew’s currently earning about $45,000. They have already maximized their RRSP and TFSA contributions. In order to maximize their investment opportunities while minimizing their taxes, they have decided that instead of Matthew contributing to the bills, Amanda will pay them all, and he will invest the money that would have otherwise gone toward bill payments in a diversified non-registered account. This account generates interest income, dividend income, and occasionally capital gains, all taxable at a much lower marginal rate.
Employing Your Spouse
Imagine a different family. Let’s suppose that James is a software architect who works fulltime from his home office. It is a lucrative profession, but he has no patience for billing, bookkeeping or managing his taxes. His wife, Kimberly, was a high school business and economics teacher for many years before leaving that career behind after their third child was born. A few years ago, she updated her business skills and opened her own part-time bookkeeping service. One of her clients is James. Once again, this has the effect of reducing the higher earning spouse’s taxable income while increasing the income for the lower earning spouse.
Some of these strategies are more useful to certain households than others. Certainly, single individuals lose out on the opportunities that are available to married couples. Couples who earn similar levels of income may only find a few of these strategies applicable. Even so, considering ways in which you can legitimately reduce your taxes is seldom time wasted.
My next post will discuss taxation of investment income.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.