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Lesson 14: Income Splitting with Your Family
So first things first — what is income splitting? Income splitting involves shifting income from the hands of one individual who pays tax at a high rate to another who will pay tax at a lower rate. For example, if a husband gives money to his wife for investment purposes, and the wife is taxed at a lower tax rate than the husband, income splitting is achieved if the investment income can be taxed in the hands of the wife as opposed to the husband. The tax savings from income splitting can be substantial.
Income Splitting in Action
Let's look at an example. Rick lives in Ontario and currently earns $60,000 per year. Of this $60,000, the taxman comes along and takes about $14,400. Ouch! But suppose both Rick and his wife Faye work and each bring home $30,000. The total family income stays the same, but the taxman's cut is greatly reduced. In this case, the total family tax bill is just $10,000 — a tax saving of $4,400. Why the tax saving? Well, when Rick and Faye each earned $30,000, every dollar earned was taxed at a tax rate of about 22 percent. However, when Rick was the sole income-earner, every dollar earned in excess of $30,755 was taxed at higher marginal rates — up to 33 percent, in fact. This higher tax rate naturally results in a higher tax bill.
Every Game Has Its Rules
Splitting income sounds really easy and straightforward, right? Wrong! If a tax strategy makes big promises, and is easy to do, you're in for a disappointment because it probably won't work. And just to prove this theory holds true, the Canada Customs and Revenue Agency (CCRA) came in and rained on everyone's parade by introducing the attribution rules. If you're looking for some light reading (huh!), the attribution rules can be found in section 74.1 of the Income Tax Act. Fortunately for those who don't require any leisure reading, we'll present a summary of how the attribution rules work. These rules state that if you try to pass income-producing property (for example, property that earns dividends, interest, rents, and royalties) to your spouse, or to a child, grandchild, in-law, niece, or nephew under the age of 18, you — not they — will be taxed on the income earned on this property.
Notice that capital gains are not included in the list of income that gets caught under these rules. Although capital gains from property transferred to a spouse will be subject to attribution rules, capital gains earned in the hands of a minor child are not subject to attribution. This means that it is possible to split income with a minor child by having the child place the transferred funds in investments that will primarily earn capital gains. Equity mutual funds are generally a good choice.
The attribution rules are sticky. Oftentimes people are caught under these rules and don't even know it! Here is a summary of the rules that you should refer to whenever you give a gift or loan money to a family member.
Transfers to a spouse
If you gift or loan money to your spouse, here's how the attribution rules will impact on you:
- Gift money. If the money is invested by your spouse, all investment income (interest, dividends, rents, and royalties) and capital gains are attributed back to the transferor.
- Loan money with no interest. Attribute all investment income (interest, dividends, rents, and royalties) and capital gains earned on the investment of the loan proceeds back to the transferor.
- Loan money with interest. No attribution if interest is charged at the lower of lending rate or the CCRA prescribed rate, and paid by January 30.
Transfers to a minor
If you're thinking of gifting or loaning money to a minor, check this list to make sure you don't get caught by the attribution rules:
Transfers to an adult child
The attribution rules provide you with a little slack when you give or loan money to an adult child. However, some income is still caught under the rules, so check out the list below:
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