The practice of income splitting has been around for decades. Essentially it is the process of shifting income recognition from a high tax bracket individual to a low bracket individual, most often carried out between spouses.
With the implementation of the tax-free savings account (TFSA) in 2009, another legal avenue has opened up for those seeking to reduce household tax costs, both on its own and potentially in coordination with existing strategies.
Existing splitting strategies
Tax authorities will often seek to impugn aggressive splitting practices by attributing income apparently earned by a low bracket spouse back to a high bracket spouse. Still, there are many common strategies that are allowed and indeed encouraged by our income tax laws.
Second-generation income – Once income has been earned and recognized, the income on that income is taxable to the receiver spouse. For this reason, one may choose to turn over such a portfolio more often in order to move more quickly into next generation income.
Spousal loans – Income earned on money loaned from a high bracket spouse to a low bracket spouse will be taxed in the latter’s hands so long as required interest is paid. Ironically, the recent economic downturn carried with it a positive twist for such loans as the prescribed rate has been at its lowest calculated point of 1% for the last year.
Fair market value exchanges – If a low bracket spouse provides assets of fair market value equal to money provided by the high bracket spouse, income earned on that money will be taxed to the receiving spouse.
Pension income splitting – Since 2008, one may elect to have up to 50% of certain pension type income sources allocated and taxed to a spouse.
Spousal RRSP – Contributions to a spousal RRSP may be withdrawn by that spouse and taxed to him or her in the 3rd calendar year after last contribution. While taking care not to imperil later retirement needs, some such withdrawals could be timed to coincide with a spouse’s temporary low income period, such as a sabbatical or maternity leave.
CPP pension sharing – Spouses may pool and then split their pension credits in order to shift some of the entitlement and taxation to the low income spouse.
TFSA strategies
One may provide money for a spouse’s TFSA, and the growth in value of the TFSA will belong to that spouse. Essentially there is no income to be attributed. That’s a $5,000 non-attributable deposit generating tax-sheltered income each year, with that figure indexed to inflation every 3 or 4 years.
To put the value of TFSA contribution room in perspective, remember that TFSA deposits are after-tax. For a rough estimate of how that compares to pre-tax RRSP room, one divides by “1 minus marginal tax rate”. For two spouses operating under a single income in a 45% bracket, their combined TFSA room equates to about $18,000 as a pre-tax figure – almost doubling the $21,000 tax sheltering room available under the RRSP alone in 2010.
If desired, that receiving low bracket spouse could pledge the TFSA as collateral to a lender in order to leverage invested assets. As legal owner of the TFSA, all associated income would be that of the low income spouse, and of course the interest charges should be deductible.
Arguably, the receiving spouse could employ the earnings from this leveraged strategy to assist in existing splitting strategies, for example to facilitate the eventual retirement of outstanding prescribed rate loans. Care must be taken however to assure that the particular steps do not cross one over into the TFSA advantage rules and/or fall within the purview of the GAAR. For these reasons, qualified tax advice should be sought before undertaking any more elaborate steps beyond plain vanilla spousal TFSA contributions.
Whether wealthy or not, the TFSA rules offer one further advantage to spouses, which is the ability to name a spouse as successor account holder. At death, the account may roll to the survivor spouse, while having no effect on his or her TFSA room. Be aware though that any unused TFSA room of the deceased spouse is forever lost.
Accordingly, in situations where a serious illness has thrust upon the couple the need for terminal estate planning, it may be prudent to fund-up a TFSA before death, using a loan if necessary. The loan could be retired after account transfer following death, thus preserving as much tax sheltering as possible for the widowed spouse.