While everyone understands that taxes are a vital part of keeping necessities like infrastructure and public services running, a hefty tax bill can put a real strain on your personal finances, especially if you’re not prepared.
Many married couples or common-law partners choose to alleviate some of that tax burden through a practice called income splitting. The goal of income splitting (also known as pension splitting) is to reduce a household’s overall tax bracket. However, only eligible pension income is authorized to be split in this way.
Income splitting, explained
Income splitting in Canada is the practice of having the higher-earning partner transfer a part of their income to the lower-earning partner, so that both end up with similar income levels for tax purposes. This can reduce the tax owed by your household, as you’re allowed to split up to 50% of your eligible pension income with your spouse or common-law partner.
The most common form of income splitting takes place during retirement.
No matter your age, if you’re planning for retirement, you can set yourself up early to make income splitting easier in the future, says Damir Alnsour, an advisor at Wealthsimple. The way to do that is to ensure that the higher-earning partner is already mindful of distributing savings in a way that will guarantee they’re not all sitting in one place, and, therefore, vulnerable to higher taxes.
Here’s an example: if Isabella makes $300,000 but Osman makes $70,000 while they’re both in their late 30s, then Isabella will be able to save more, because she has more income to put aside. But instead of placing it all into her Registered Retirement Savings Plan (RRSP), she could put part of it in a spousal RRSP, so that the two spouses’ RRSPs will be even by the time Isabella and Osman retire. If they were to only draw income from one large RRSP, their tax burden would be higher than if they withdrew from two smaller ones.
One more thing: while spousal income splitting in Canada is usually talked about within the context of retirement planning, Alnsour notes that there are other examples too. “There’s income splitting before retirement, but that’s a much more complicated scenario,” he says. “One strategy would be to implement something called a spousal loan, where one spouse lends another spouse money, and that spouse uses the money to earn investment income.”
Advantages of income splitting
While pension income splitting is beneficial for all couples who have disparate income levels, it’s particularly beneficial for high-income earners who would otherwise be in much higher tax brackets. This is particularly relevant when retirement comes along. Although you might not be working, you will likely be receiving income from sources such as your investment accounts, and if you have a large income from these accounts, you’ll be in a high tax bracket. In this scenario, income splitting can bring your tax obligation down.
“You’d want an income split if you’re in retirement and you [and your spouse] end up in different tax brackets,” Alnsour says. “Income splitting will let you reduce your overall tax bill.”
The only time income splitting would probably be unnecessary, he adds, is when you and your partner end up in the same tax bracket during retirement and have similar RRSPs or pensions.
Alnsour also points out another lesser-known benefit of income splitting: the Canadian government allows every retiree with an eligible pension amount a tax credit of $2,000, also known as the Pension Income Amount. This means that the first $2,000 of your annual pension income is essentially tax-free if you’re in the first tax bracket.
“If you split your pension, it allows a spouse who doesn’t currently receive a pension to claim that tax credit as well,” Alnsour says. “That’s another reason why you might want to split your income, because now you’ll both receive $2,000 in pension tax credits.”
Types of income eligible for income splitting
Not every type of income — or every type of taxpayer — is eligible for income splitting.
If you and your common-law partner or spouse want to split incomes, the partner receiving the pension needs to be at least 65 years of age. While you can also split your income if you’re both under 65, your qualified income will be limited to Registered Pension Plan payments, or specific annuities and benefits you received because of the death of a spouse — see the Canada Revenue Agency’s Eligible Pension and Annuity Income (less than 65 years of age) chart for details.
To be eligible for income splitting, both of you also have to reside in Canada and live together during the tax year for which you’re reporting the income split. (There are certain exceptions that apply when one of the partners lives abroad or is separated for medical, educational, or business purposes.) So, if Isabella and Osman were currently separated and living apart at the end of the tax year, they wouldn’t be able to split their income.
It’s also important to keep in mind that only certain types of income are eligible for income splitting. Eligible types of income are: any income derived from a Registered Retirement Income Fund (RRIF) or from an RRSP, as well as life annuity income. The exception to that is amounts from an RRIF included on line 11500 and transferred to an RRSP, another RRIF, or an annuity. Government benefits such as Old Age Security payments and income derived from the Canada Pension Plan or the Québec Pension Plan are not eligible for income splitting. Income derived from a United States individual retirement account is also not eligible.
You can find more detailed information about who and what is eligible for income splitting on the Canada Revenue Agency’s website.
How income splitting works
Income splitting is an electable action that you opt in to every year when you file your taxes. To do so, both you and your spouse or partner have to complete and file the Canada Revenue Agency’s form T1032, Joint Election to Split Pension Income.
Unfortunately, form T1032 isn’t exactly the clearest of forms, so people will often choose to get help from their accountant or use a tax prep software such as Wealthsimple Tax, which will help ensure they’re filling out the form correctly. Taxpayers have to fill out a new form T1032 for every year they choose to split their income.
