A headline this week announced that the Conservative government might be backing down on a 2011 promise to reduce the income tax burden on families by allowing income splitting with children.
The Tories had been saying they would start reducing income taxes next year, once they had a confirmed budget surplus. Some of this reduction would be through a concept called “income splitting”. However, a report this week suggests the government may back down on this promise, since income splitting would mostly benefit high-income families. It might do very little for the middle class, which coincidently has more votes.
So, what is income splitting, and can you use the concept to reduce your income taxes now, under the current rules?
Let’s explain, and see how thinking along these lines might help your tax return.
Canada has a progressive tax system. That means as your income increases, your marginal tax rate (the rate charged on the next dollar you earn) increases.
For example, in Manitoba, the marginal tax rate is 25.8% on employment or interest income for a person with taxable income between roughly $10,000 and $31,000. So, if a person earning $20,000 gets a $1,000 raise, $258 will go to federal and provincial income taxes. (This does not include the additional withholdings for CPP, EI and any company benefits.) If that person earns $1,000 of interest income on investments, the taxes will be $258. On $1,000 of eligible dividends, the tax would be only $40 or less, thanks to the dividend tax credit.
Now, let’s assume that person’s spouse has taxable income of $70,000, and earns $1,000 of interest income. In the higher marginal tax bracket, the spouse will pay $394 of tax on that interest, and about $200 on $1,000 of dividends.
So, in this situation, it is obviously better for the lower income spouse to accumulate the investments (that are outside RRSP or TFSA), so that less tax is paid on the investment income.
To turbocharge this benefit, income would somehow be transferred to the zero tax rate of minor children, who can earn up to roughly $10,000 each with no tax payable at all. This is what the 2011 Conservative announcement promised, that up to $50,000 of taxable income could be split with kids.
The current CRA rules prohibit this, of course. They require that the person who owns the capital (the one who earned it or inherited it) must invest it and claim the investment income. The strategy we use, therefore, is to have the lower income spouse do the saving, while spending the higher income spouse’s income.
If possible, good estate planning also means arranging for future inheritances to be received by the lower income spouse, or at least the spouses jointly. (I understand there may be many complications in actually implementing such a plan.)
When setting up an incorporated business, we always want to make sure that lower income family members or a family trust with low income beneficiaries owns shares, so that dividends can be allocated out to the kids or lower income spouse.
When a high income spouse has significant amounts of investment capital, this money can be loaned to a lower income spouse, at the current CRA prescribed rate of 1%, thus transferring the investment income earned to the tax return of the lower income spouse.
These procedures, and related rules about gifting between family members and claiming or deferring capital gains on transfers between spouses, are very complex, so please get good tax and investment advice before you engage in such strategies.
The one thing I can tell you for sure is that promises made by politicians may have to be modified as “circumstances change.”
Unrelated to that, congratulations to Winnipeg’s new mayor, Brian Bowman, and thank you all for voting and exercising your democratic right.
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Dollars and Sense is meant as an introduction to this topic and should not in any way be construed as a replacement for personalized professional advice.
Please consult legal, tax and investment experts for advice on your unique situation.
David Christianson, BA, CFP, R.F.P., TEP, CIMis a financial planner and advisor with Christianson Wealth Advisors, a Vice President with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.