Reducing your tax burden can be a family affair. It always amazes me how some investors - especially ones in the high net worth segment - are planning for their future but are not aware of income splitting strategies to reduce overall family taxes. This becomes especially important in the case of a high-income earner in a high tax bracket and a lower income spouse in a lower tax bracket.
Before discussing income splitting strategies, it is important to note that the Income Tax Act (Canada) contains attribution rules.
"Attribution rules can cause any income realized on property transferred to a spouse, common-law partner, other minor children or related minors in the family, to be assigned back to the transferor of the property. They apply where the property is transferred directly or through a trust," says Jennifer Poon, Director, Advanced Planning, Wealth at Sun Life Financial. "Attribution only applies to certain types of income and does not apply when the property is loaned at the prescribed rate of interest or when fair market value is paid as consideration."
Income from the transferred property (interest, dividends, etc.) is generally always attributed back to the transferor. Capital gains realized on property transferred to a spouse or common-law partner are attributed back to the transferor. However, there is no attribution of capital gains realized on property transferred to children under the age of 18.
There are some strategies that allow income splitting without attribution rules applying.
In general, it's best to have the lower income spouse save and the higher income spouse pay expenses. Building up an investment portfolio with the lower income spouse is a smart strategy since the income will be taxed in their hands at a lower rate, saving on overall tax for the household.
Take a situation like Hugo and Milena. Milena is a senior executive at a large, publicly-traded company. Her income is significant and she has built up a large investment portfolio. Hugo is a musician with limited income. Music is his passion and he plans to continue to stay in the business part-time. They have two children: Gabriel, 4, and Kara, 6. Kara is in private school and Gabriel will start next year.
Hugo and Milena are like many other clients I have come across in the past that have not taken advantage of income splitting. They're aware they are paying too much tax but like many Canadians, their finances fall to the bottom of the family's busy to-do list. The key is to get as much income out of Milena's hands as possible. There are a few strategies to consider.
The federal government recently introduced the Family Tax Cut, effective for the 2014 and subsequent taxation years, which provides a non-refundable tax credit up to $2,000 for families with children under the age of 18. It approximates tax savings as if $50,000 of income was transferred to a lower income spouse. This will be beneficial to Milena and Hugo.
Spousal Registered Retirement Savings Plans (RRSPs) are another way to income split. Milena can contribute to the RRSP for Hugo in order to receive a tax deduction. Hugo could draw funds out before retirement if required, as long as no contributions have been made by Milena in the current or previous two calendar years. It's important to plan ahead if this strategy is employed. Milena can also make contributions to Hugo's Tax Free Savings Account (TFSA ), provided he has the contribution room, without the attribution rules applying. Another option that is sometimes overlooked is a spousal loan. For example, Milena can lend Hugo $500,000 or $1 million at the prescribed rate of interest, which is set by the Canada Revenue Agency and currently at 1%. As long as Hugo makes the interest payment to Milena by January 30th of the following year, any investment income earned is taxable to Hugo at his lower rate. It's a relatively simple and effective way to income split that should be done with the advice of a tax advisor who can ensure the rules are followed and the loan is well documented.
Registered Education Savings Plans (RESPs) are a smart choice for families with children to help them save for post-secondary education. Hugo and Milena can start RESPs for Gabriel and Kara to take full advantage of the Canada Education Savings Grant program. RESPs can help with income splitting as long as the children attend a post-secondary educational institution. The income and CESG will be taxed in the children's hands, when withdrawn, at a much lower rate.
Another option for affluent families like Hugo and Milena is to consider setting up a family trust. It works best when families have a significant amount to settle into the trust or loan the trust. This may be considered for amounts over $1 million due to the costs to set up the trust and its ongoing administration. Milena could lend money to the trust and make Hugo and the children beneficiaries. After paying interest, at the prescribed rate, to Milena, the net income of the trust could be distributed out to Hugo, Gabriel or Kara and taxed in their hands. As with a spousal loan, this will have to be carefully documented and implemented with the help of a tax advisor. A family trust can be an effective way to income split. The income distributed to the beneficiaries must be used to benefit them, for example, it could be used to pay for Kara's private school tuition. The after tax cost would be much lower than Milena paying with her own after tax dollars.
Milena should focus on making her non-registered investments as tax-efficient as possible. Corporate class funds provide the potential to minimize taxable distributions and tax-deferred switching between classes of the same structure to provide tax deferrals and tax savings. She should also pay close attention to the fees she is paying to maximize her return.
Consult an advisor to come up with a tax-wise plan that fits your situation. You may be surprised at the savings that result when you can share your tax burden with your nearest and dearest.
*** This article is provided for general informational purposes only and should not be considered specific financial advice. For advice specific to your circumstances, please speak to the appropriate tax, investment or insurance advisor.
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