Tax Savings through Income Splitting

Income splitting is a strategy where two or more individuals distribute income or gains from various sources, such as business, property, or other income types. This approach can lead to significant tax savings. It’s important to distinguish between “split income” and “income splitting.” “Split income” is a part of tax avoidance measures and is taxed at the highest rates. 

Understanding Income Splitting and Tax Savings 

Canada’s personal income tax system is progressive, meaning the tax rate increases with higher income levels. There are both federal and provincial tax brackets, and the system taxes marginal income. For example, in the federal system, there are five tax brackets with rates of 15%, 20.5%, 26%, 29%, and 33%. Income up to $45,282 is taxed at 15%, and each dollar above this threshold is taxed at a higher rate. 

A common misconception is that moving into a higher tax bracket results in all income being taxed at that higher rate. However, only the income above the bracket threshold is taxed at the higher rate. For instance, if someone earns $50,000, the first $45,282 (minus the basic personal exemption) is taxed at 15%, and only the remaining amount is taxed at 20.5%. 

How Income Splitting Saves Money 

Income splitting is beneficial because it allows the distribution of a total sum between two or more individuals, subjecting it to lower tax brackets. For example, if $50,000 is split between two people, each with a taxable income of $25,000, they can both claim the basic personal exemption and pay only 15% tax on the remaining amount. This can result in significant tax savings. 

Methods of Income Splitting 

One common method of income splitting is through corporations or partnerships, especially between spouses. Both partners can share the income from the business or property, thus dividing the tax burden. However, there are new limits introduced in 2018 for income splitting using corporations. 

Another method is pension income splitting. Not all pension incomes are eligible for splitting, such as Old Age Security (OAS), Canada Pension Plan (CPP), Quebec Pension Plan (QPP), or foreign pensions exempt due to tax treaties. Eligible pension incomes include life annuity payments or payments from employer superannuation or pension funds. To split eligible pension income, both spouses must meet certain conditions and file a joint election form (T1032) with their tax returns. 

In summary, income splitting is a valuable tax strategy that allows individuals to distribute income among multiple parties, potentially resulting in lower overall tax rates and significant savings. However, it’s essential to understand the rules and limitations associated with different income splitting methods.