How Income Splitting Works

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Luisa Rollenhagen

Luisa Rollenhagen is a journalist and investor who writes about financial planning for Wealthsimple. She is a past winner of the David James Burrell Prize for journalistic achievement and her work has been published in GQ Magazine and BuzzFeed. Luisa earned her M.A. in Journalism at New York University and is now based in Berlin, Germany.

While everyone understands that taxes are a vital part of keeping necessities like infrastructure and public services running, facing a hefty tax bill can often put a real strain on your finances, especially if you’re not prepared.

That’s why many married couples or common-law partners might choose to alleviate some of that tax burden through a practice called income splitting. The goal of income splitting, which is also known as pension splitting, is to reduce a household’s overall tax bracket. Only eligible pension income is authorized to be split in this way.

Income splitting, explained

Income splitting in Canada is the practice of having the higher-earning spouse in a married couple transfer a part of their income to the lower-earning spouse so that they end up with similar income levels for tax purposes. This can reduce the tax on the split income. You’re allowed to split eligible pension income up to 50% with your spouse or common-law partner.

According to Damir Alnsour, an advisor at Wealthsimple, there are two kinds of situations in which income splitting comes into play: before retirement and during retirement.

“There’s income splitting before retirement, but that’s a much more complicated scenario,” he says. “One strategy would be to implement something called a spousal loan, where one spouse lends another spouse money, and that spouse uses the money to earn investment income.”

However, because the most common form of income splitting takes place during retirement.

(While spousal income splitting in Canada is usually talked about within the context of retirement, Alnsour suggests that it’s smart to start setting yourself up for optimal tax breaks as soon as you can.)

“If you’re in your 30s and 40s, and you’re planning for retirement, you can set yourself up in a way where pension/income splitting is done in an easier fashion,” he says. The way to do that is to ensure that the higher-earning partner is already mindful of distributing savings in a way that will guarantee that they’re not sitting all in one place.

Here’s an example: If Isabella makes $300,000 but Osman makes $70,000 while they’re both in their late 30s, then Isabella will be able to save more because she has more income to put aside. But instead of placing it all into her RRSP, she could put part of it in a spousal RRSP so that the two spouses’ RRSPs will be even by the time Isabella and Osman retire. If they were to draw income from one large RRSP, their tax burden would be higher than if they withdrew from two smaller ones.

Advantages of income splitting

While pension income splitting is beneficial for all couples who have disparate income levels, it’s particularly beneficial for high-income earners who would otherwise be in much higher tax brackets. This is particularly relevant when retirement comes along. Although you might not be working, you will likely be receiving income from sources such as your investment accounts. If you have a large income from your accounts, you’ll be in a high tax bracket. Income splitting can bring your tax obligation down in this scenario.

“You’d want to income split if you’re in retirement and you [and your spouse] end up in different tax brackets,” Alnsour says. “Income splitting will let you reduce your overall tax bill.”

The only time income splitting would probably be unnecessary is when you and your partner end up in the same tax bracket during retirement and have similar RSPs or pensions, he adds.

Alnsour also points out another lesser-known benefit of income splitting: The Canadian government allows every retiree with an eligible pension amount a tax credit of $2,000, also known as the Pension Income Amount. This means that the first $2,000 of your annual pension income is essentially tax-free if you’re in the first tax bracket.

“If you split your pension, it allows a spouse who doesn’t currently receive a pension to claim that tax credit as well,” Alnsour says. “That’s another reason why you might want to income split, because now you both receive $2,000 in pension tax credits.”

Types of income eligible for income splitting

Not every type of income—or every type of taxpayer—is eligible for income splitting.

If you and your common-law partner or spouse want to split incomes, the partner receiving the pension needs to be at least 65 years of age. You can also split your income if you’re under 65, but your qualified pension income is limited to registered pension plan payments and certain annuities and benefits that you received because of the death of a spouse. See the Canada Revenue Agency’s Eligible Pension and Annuity Income (less than 65 years of age) chart for details.

To be eligible to do this maneuver, both of you also have to reside in Canada and live together during the tax year for which you’re reporting the income split. There are certain exceptions that apply when one of the partners lives abroad or is separated for medical, educational, or business purposes, but for the most part you have to be living together in Canada. So, if Isabella and Osman were currently separated and living apart at the end of the tax year, they wouldn’t be able to split their income.

It’s also important to keep in mind that only certain types of income are eligible for income splitting. Eligible types of income are: Any income derived from a Registered Retirement Income Fund (RRIF) or from a Registered Retirement Savings Plan (RRSP), as well as life annuity income. The exception to that is amounts from a RRIF included on line 11500 and transferred to an RRSP, another RRIF or an annuity. Government benefits such as Old Age Security (OAS) payments, and income derived from the Canada Pension Plan (CPP) or the Quebec Pension Plan are not eligible for income splitting. Income derived from a United States individual retirement account (IRA) is also not eligible.

You can find more detailed information about who and what is eligible for income splitting on the Canada Revenue Service’s website.

How income splitting works

Income splitting is an electable action that you opt-in to every year when you file your taxes. To do so, both you and your spouse or partner have to complete and file the Canada Revenue Agency’s form T1032, Joint Election to Split Pension Income.

However, form T1032 isn’t exactly the most comprehensible of forms, so people will often choose to get help from their accountant or use a tax prep software such as Wealthsimple Tax, which will help ensure they’re filling out the form correctly. Taxpayers have to fill out a new form T1032 for every year they choose to split the income.

Frequently Asked Questions

Income splitting is a method of bringing a married couple’s tax bracket down by transferring a portion of the higher-earning spouse’s income to the lower-earning spouse as eventual retirement income. Common-law partners are eligible to use this practice as well.

Income splitting in Canada works by having both partners elect to split income when filing their taxes every year. They must fill out form T1032 to elect to split their income.

To be eligible to split income in Canada, the spouses or common law spouses must live together in Canada during the appropriate tax year, except in certain cases involving medical, educational, or business issues.

The benefit of splitting pension income is bringing your household’s income into a lower total tax bracket and therefore paying less in taxes.

Only income derived from a Registered Retirement Income Fund (RRIF) or from a Registered Retirement Savings Plan (RRSP) can be split between spouses.

The rules for income splitting in Canada require that the partners looking to split the income lived together in Canada within the tax year for which they are splitting income. They can be legally married or common law spouses. They can split any income that is coming from an RRIF or RRSP account. They must fill out form T1032 each year they elect to split income.

Pension splitting can be a good thing if one spouse in a couple makes a lot more than the other. Splitting income in this case can bring the household’s tax bracket down, allowing the couple to pay less in taxes.

Last Updated April 29, 2022

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