Tax Planning – What to Do if You’re Not Keen on Reducing Expenses
Tax Planning – Share Income with Your Family, Not Ottawa – December 4, 2012
Many people seem to consider their tax situation for a few painful hours each year when completing their tax returns or passing off the paperwork to their accountants.
Although your number cruncher may be a miracle worker and your software program top notch, they can only work with the cards they are dealt. In many cases, to truly maximize savings, you may need to plan many years in advance so that you can hand your accountant a royal flush rather than a pair of 4’s and winning smile.
I’ll talk about some of the ways of legally reducing your contribution to the folks in Ottawa in later articles but for now, I’ll just focus on income splitting. What is this you might ask? I define this as legally arranging your family’s affairs so that more income is taxed in the hands of family members who won’t have to pay as much tax on the cash.
Expanding on this concept, income splitting works because our tax system is ‘progressive.’ Unfortunately, this does not mean enlightened or possessed of new age wisdom. It simply means that instead of paying a flat tax rate, regardless of how much you earn, tax payers pay a higher rate on any income they receive above set thresholds, although any amounts below that amount are still taxed at lower rates.
For example, if Peter earned $50,000, he might not have to pay any tax on the first $10,000 he earned, 20% on the portion between $10,000 and $40,000 and 30% on the excess. If his wife Mary made only $30,000, she would still earn $10,000 tax-free and would pay tax on 20% of the rest. If Peter could legally transfer the last $10,000 he earned to Mary, this would mean that both Peter and Mary would be taxed on $40,000. Although Mary’s tax bill would go up by $2,000 ($10,000 x 20%), Peter’s would go down by $3,000 ($10,000 x 30%). In other words, our friends in Ottawa would need to learn how to make do with $1,000 less and our happy couple might be able to afford that trip to Hawaii after all.
Although income splitting between spouses is probably most common, don’t forget about the kids! Since all taxpayers, regardless of age, can earn about $10,400 tax-free, the real savings might come by transferring income a wealthy mom or a loaded dad to a deadbeat child. In B.C. the highest tax rate is currently 43.7%, which applies if you make more than around $135,000. Let’s assume Bob is a single dad with 18 year-old twins, Paul and Art. If Paul would have otherwise earned $155,000 but was allowed to transfer $10,000 to each of his boys instead, the family would save $8,740 in taxes if he didn’t have to pay tax on the whole amount himself – enough to pay music school tuition for both of the lads.
Although there are a few exceptions, most income splitting needs to be done before the high income earner receives the money. In other words, by the time you hand your receipts to your accountant, the income-splitting ship has probably already set sail for that year. On the other hand, that same instant may be the perfect moment to start taking steps to minimize your tax bill for the next year, 20 years from now or even at your death.
Unfortunately, our friends in Ottawa have put a few rules in place to restrict income-splitting in certain cases, particularly with spouses and minor children. Rather than dwell on the negatives, I’d rather talk about some of the avenues still open to tax-savvy citizens. Here are a few of the many strategies that Canadians employ every day to hang onto more of their money:
- Spousal Loans. If a high income spouse also has non-registered assets, while her spouse is in a lower tax bracket, she can lend her spouse the money at a set government rate (currently 1%). So long as the low income spouse pays interest to his wife by January 30 of the ensuing year, they can tax any investment profits in his hands at his rates. The high income spouse does have to declare the interest on her tax return but the low income hubby can claim the same amount as a tax deduction. The loan must be properly documented. As an added bonus, the interest rate on the loan can be fixed for life at the current low rate.
- Spend and Save. The higher income spouse uses all of his income to pay family expenses and fund both spouses’ TFSAs, leaving the low income spouse her excess income to throw into the stock market. She won’t pay as much tax on her investment income as he would have, which means more money in the family. One word of caution: the couple would want to ensure that the high income spouse has enough money left over to maximize his RRSP contributions and, depending on her tax rate, maybe fund her RRSP as well.
- RRIF and Pension Income-Splitting Rules. The government threw Canadians a bone about 4 years ago when it allowed citizens to allocate up to 50% of their work pension and RRIF income (once the spouse first earning the RRIF is 65) to their low income spouse each year. Even better, they don’t have to decide how much to allocate that year until tax time, when they can determine how to achieve the best result.
- Spousal RRSPs. Although the pension income-splitting rules will help many couples, Spousal RRSPs may offer an even better result in many cases. Spousal RRSPs work just like regular RRSPs, except the contributing spouse funds a separate RRSP in his spouse’s name using his contribution space and claiming the deduction on his return. So long as the receiving spouse waits 3 tax years, including the year of contribution, before withdrawing the money, 100% of it will be taxed in her hands at her rates. This presents many opportunities for savings, such as:
- Providing money the receiving spouse can use towards the RRSP homebuyers plan so that each spouse will have $25,000 available subject to time restrictions;
- Allowing the high income spouse to maximize RRSP contributions even if this means that the low income spouse can’t contribute as much or any, other than enough to take advantage of employer matching opportunities. Since the Spousal RRSP money will be taxed in the low income spouse’s hands on withdrawal anyway, the couple may want to focus on first maximizing the high income spouse’ s contributions first, since they produce a higher tax refund;
- Providing opportunities for the low income spouse to withdraw Spousal RRSP money during low or no income years, such as if she is at stay-at-home mother or if he goes back to school or if that spouse plans on taking early retirement; and
- Pushing back the year when money must be withdrawn from a RRIF if the receiving spouse is younger than the gifting spouse;
- Family Trusts. If the family business is incorporated, setting up a family trust or having different family members own different types of shares in the company can provide huge tax savings. Although businesses can only pay salaries to various family members that are reasonable in light of the tasks performed, there is no restriction on how dividends from the company can be allocated to family members 18 years or older. This allows mom and dad to allocate dividends to their older children and use these kids’ tax returns to dramatically reduce the tax otherwise payable.
- RESPs. Besides the 20% government match on qualifying donations and tax deferral until withdrawal, RESPs also tax the growth and government grant portion of the RESPs in the kids’ hands rather than mom or dad’s. This might mean “tax-free” in many cases. As an added bonus, mom or dad can recoup any unused portion of their original contribution (but not the profits or government grants) tax-free.
These are just a few of the potential opportunities available. Contact me if you want to see if any of these or other opportunities apply to your situation.