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 vital 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.
What is income splitting?
Let’s say Isabella is married to Osman. Isabella makes $30,000 a year, while Osman makes $90,000. That places Osman in a higher tax bracket than Isabella, meaning that he probably has to pay significantly more than her. However, if Isabella and Osman spread their income evenly among themselves, then their overall tax level will be lower than if they remained at their original corresponding levels.Wealthsimple Invest is an automated way to grow your money like the worlds most sophisticated investors. Get started and we'll build you a personalized investment portfolio in a matter of minutes.
This is essentially the goal of income splitting: To reduce a household’s overall tax bracket by having the higher-earning spouse transfer a part of their income to the lower-earning spouse so that they end up with a pretty similar income level, at least for tax purposes. You’re also allowed to split up to 50% of your income with your spouse or common-law partner.
According to Damir Alnsour, a portfolio manager at Wealthsimple, there are two kinds of situations where 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, most financial planning will refer to this specific scenario.
But while income splitting 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.
If Isabella makes $300,000 but Osman only makes $70,000 while they’re both in their late 30s, then Isabella will be able to save more, simply 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, by the time Isabella and Osman retire, their RRSPs would be pretty even and they’d have fairly level sources of income during retirement from which they could draw. If they simply drew income from one large RRSP, their tax burden would be higher than if they withdrew from two smaller ones.
Advantages of income splitting
While 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.
Let’s go back to Isabella and Osman. Let’s say Osman and Isabella are retiring, and Isabella has a pretty respectable investment fund that generates about $50,000 in income. Osman’s investment account, on the other hand, generates almost no income. Usually, Isabella would be faced with a pretty hefty tax bill, since she would be in a higher tax bracket. But if she split that income with Osman on their taxes, then Osman would be pushed into a higher bracket while Isabella would be pushed down, essentially leveling them out and lowering the overall tax burden of their household. Both Isabella and Osman would then report $25,000 each as their individual income; their overall tax bill would be lower as a result.
“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 pretty similar RSPs or pensions, he adds.
Alnsour also points out another lesser-known benefit of income splitting: The Canadian government allows every retiree a tax credit of $2,000, also known as the Pension Income Tax Credit. This means that the first $2,000 off of your annual pension income is essentially tax-free. “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 spending.
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 income split 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.
Both of you would 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. Government benefits such as Old Age Security (OAS) payments, 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.
Here’s what is eligible for income splitting: Any income derived from a Registered Retirement Income Fund (RRIF) or from a Registered Retirement Savings Plan (RRSP), as well as life annuity income. You can find more detailed information about who and what is eligible for income splitting on the Canada Revenue Service’s website here.
How income splitting works
Income splitting is an electable action that you opt-in on every year when you file your taxes. Both you and your spouse or partner would 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 SimpleTax, which will help ensure the form is filled out correctly.
After that, you’ll have to fill out a new form T1032 for every year you choose to income split.