Income splitting can lighten your tax load: proven strategies can be effective, but rules and limits apply

Money Digest, May, 1999

Is your income being taxed at the highest marginal rate? If so, you are paying a combined federal and Ontario tax rate of about 50%. However, you may be able to save some tax dollars through income splitting. Here's how it works.

"Income splitting simply means spreading your income among other family members with lower marginal tax rates," says Brian Quinlan, CA, of Campbell Lawless in Toronto. "As a result, the family's overall tax burden will be decreased, and they will have more cash to fund their everyday living expenses."

If you are self-employed, one way to split your income is to hire your child to work in your business. This permits you to deduct the child's salary from your business income for tax purposes.

"You can deduct this amount as long as you pay the salary, the work carried out is necessary for earning business or professional income, and the salary is reasonable, taking into account things like the child's age and what you would pay someone else to do the same job," says Heather O'Hagan, CA, of KPMG in Toronto.

Be sure to document the salary you pay your child, either through cancelled cheques or signed receipts, and to issue a T4 slip. "The child must report this income for tax purposes, but it's likely to be taxed at a low rate," adds O'Hagan.

Another effective income-splitting technique is contributing to a spousal Registered Retirement Savings Plan (RRSP). In a spousal RRSP, the person who expects to have the higher retirement income makes an RRSP contribution to his or her spouse's plan who is the plan's annuitant.

"A spousal RRSP helps equalize a couple's retirement income," explains Quinlan. "When spouses' retirement incomes are about the same, it usually means the couple will pay lower total taxes," he says.

Income splitting strategies:

* Hire your child to work in your business

* Contribute to a spousal RRSP

* Arrange your finances so that the higher-income spouse pays as many of the family living expenses as possible

* Lend or transfer property to your spouse or a relative under the age of 18

If you make a contribution to a spousal RRSP, you get the income tax deduction. You can put money into both your own RRSP and into the spousal RRSP, but the total contribution must be within your maximum RRSP limit for the year. Your spouse, meanwhile, can also contribute to a spousal RRSP, according to his or her own contribution limit.

"If you are over the age of 69 you can no longer contribute to your own RRSP, but you can contribute to your spouse's RRSP if he or she is 69 or younger," Quinlan adds.

Another income-splitting strategy is to arrange your finances so that the higher-income spouse pays as many of the family living expenses as possible. "this permits the income of the lower-taxed spouse to be saved and invested," says O'Hagan.

Other options including lending or transferring property to your spouse or to a relative under the age of 18. However a number of rules apply.

"If you make such a loan or transfer, any income or loss from the property is attributed to you and is taxed in your hands," cautions Quinlan. "The same attribution rules apply to low-interest or interest-free loans to relatives, where the loan is made to reduce income tax."

However, if you charge interest at no less than Revenue Canada's prescribed quarterly rate, the attribution rules won't apply. The interest income must be included in your taxable income, but the low income loan recipient will likely get a tax deduction on the interest payment.

Other income-splitting strategies include investing Child Tax Benefit payments in your child's name, setting up a Registered Education Savings Plan, and making cash gifts to your children over the age of 18.

Income splitting can be an effective tax reduction strategy, but a number of rules and limits apply.