Income splitting is a general phrase that refers to many ways in which two or more persons can distribute income or gains from business or property, or from other sources of income. Income splitting, where possible, can result in substantial tax savings.
Note that “split income” is not the same thing as “income splitting”; “split income” is part of a tax avoidance measure that taxes “split income” at the highest tax rates.
How are savings achieved through Income splitting? Canada’s personal income tax system is a graduated system. This means that the percent of tax on income increases as a person’s income increases through the various tax brackets. There are federal and provincial tax brackets. The system is also based on marginal income, meaning that income below a cut-off is taxed at a lower rate and only each dollar above a cut-off is taxed at a higher rate.
For simplicity, we will consider federal tax brackets for purposes of this article. Canada has 5 official tax brackets (and a 6th if we take into account the personal exemption). The tax rates for these brackets are 15%, 20.5%, 26%, 29%, and 33%. The first tax bracket is income up to $45,282 of taxable income. This means that every dollar up to $45,282 and above the basic personal exemption amount (in 2017 this was $11,635 federally), is taxed at 15%. Any dollar above is in the next tax bracket and taxed at a higher rate, and so on for each tax bracket. Note that most people think that if you get pushed into a higher tax bracket, then your entire income is taxed at the higher rate. This is not true. If you make $50,000 in 2017, then the first $45,282 (less the basic personal exemption) is taxed at 15% and only the last $318 is taxed at 20.5%.
The reason income splitting saves money is that it allows a total sum to be distributed between two or more persons, and therefore be subject to lower tax brackets. For example, a person making $50,000 would be taxable on the entire amount and would reach into the 20.5% tax bracket. But if this money is divided between two people, then each would have taxable income of $25,000, can each claim the basic personal exemption ($11,635) and each only has to pay 15% tax on the remaining $9,135. This results in a savings of about $2,800 for an Ontario resident. This is quite a savings.
What is one way in which persons can split income? The most common way in which persons split income is with their spouses through the use of a corporation or a partnership. For example, where both spouses are partners in a partnership or both are shareholders of a corporation, they can divide the income from the business or property source of that corporation or partnership amongst themselves. There are some new limits introduced for 2018 that limit the eligibility for income splitting using corporations, but they are too lengthy to consider in this article.
Another very common income splitting method is the splitting of pension income. However, not all pension income is eligible to be split amongst spouses or common-law partners. Pension income that is NOT eligible for income splitting includes Old Age Security payment (OAS), Canada Pension Plan payments (CPP), Quebec Pension Plan payments (QPP), or other foreign pension income that is exempt from tax because of a tax treaty. Eligible pension income includes taxable part of life annuity payments, or payment from a superannuation or pension fund from employers. To be entitled to split eligible pension income, the following conditions have to be met:
- You and your spouse were not living separate and apart because of breakdown of the relationships
- You and your spouse are both resident of Canada on December 31 of the year, or resident of Canada at the date of death if deceased in the year.
If you are living separate and apart for educational, business, or medical reasons, you can still split eligible pension income with your spouse or common-law partner.
To split eligible pension income, both spouses or common-law partners have to fill out a joint election, form T1032 “Joint Election to Split Pension Income”, and file it with their tax returns.