Income Splitting Explained
Canadians pay a significant amount in taxes. Among the 38 member countries of the Organisation for Economic Co-operation and Development (OECD), Canada had a tax-to-GDP ratio of 34.4% in 2020, compared with the OECD average of 33.5%. The Fraser Institute declared Tax Freedom Day on June 15, 2022, which they define as follows:
“If you had to pay all your federal, provincial and municipal taxes up front, you would give the government every dollar you earned from January 1st to Tax Freedom Day, when Canadians finally start working for themselves. In 2022, the average Canadian family (with two or more people) will pay 45.2% of its annual income in taxes, including income taxes, payroll taxes, health taxes, sales taxes, property taxes, fuel taxes, carbon taxes, and more.”
Income taxes account for a significant portion of these tax funds, as evident in the income tax numbers posted at the end of this article.
Most would agree that working until June 15th before enjoying the fruits of your labor is far from the ideal scenario we envisioned as children planning our futures. However, there are ways to reduce this tax burden, and one of the best strategies is through income splitting.
What is Income Splitting?
“Simply put,” explains WealthCo Senior Planner Ryan Mackiewich, “income splitting involves taking one person’s income and sharing it with another person.”
Income splitting is a tax strategy used by many Canadians to reduce their overall tax liability.
“By transferring income from a high-income earner to a low-income spouse or dependent,” Mackiewich continues, “taxpayers can take advantage of lower marginal tax rates and receive other benefits such as increased government benefits and credits.”
This act of transferring income from a higher-earning spouse to a lower-earning spouse divides the total household income into two lower taxable brackets, resulting in a reduction in the overall amount of taxes paid. Income splitting can be especially beneficial for families with children, as the lower-earning parent may be able to claim various childcare credits and deductions.
Recent Changes to Income Splitting
In December 2017, the Canadian government implemented a new set of rules known as the "tax on split income" (TOSI), which limits the ability to income split.
“Prior to the TOSI rules, there were many legal and accepted ways to split income,” Mackiewich explains. “There were more ways to split or share property income, business income, personal income, and investment income. Under TOSI, only certain types of income can be split. This has had a big impact on small family businesses, commonly professional service providers like doctors, lawyers, and accountants, who used income splitting. These rules changed to allow income splitting only when someone worked a sufficient amount in the business or reached a certain age.”
Additional impacts from TOSI include:
Limitations on how certain types of income, such as dividends from private corporations, can be split.
Exclusions for taxpayers under the age of 18 and for certain family trusts.
Restrictions that may prevent parents from claiming childcare expenses.
Effects on estate planning, such as limiting the ability to transfer assets to family members at a lower tax rate.
How You Can Make Income Splitting Work for You
While income splitting can be a beneficial way to reduce taxes, it is important to be aware of the rules and restrictions to avoid penalties. For example, knowing what types of income are eligible for splitting and understanding the limits on the amount that can be transferred. Additionally, income splitting may not be advantageous in all cases, such as when both spouses have similar incomes.
“While income splitting is perfectly legal, it can be complex and should only be undertaken with the help of a qualified accountant,” Mackiewich cautions. “Especially given the changes brought on by TOSI, a tax expert, such as your accountant, is your best guide for navigating these changes.”
Unclear on whether income splitting is a viable option for your unique situation? Your trusted advisor, your accountant, can answer this question and discuss any additional tax mitigation strategies that might be worth considering.
Ryan Mackiewich, CPA, CA, FEA, is a Senior Planner with WealthCo and a member of WealthCo’s Integrated Advisory community. With over 25 years as a CPA, CA providing tax and business advisory expertise, Ryan also holds the Family Enterprise Advisor (FEA) designation and works with business families to help them effectively transition business, wealth, and roles. When not advising clients, Ryan enjoys camping, hiking, and exploring the world.
The Integrated Advisory community consists of a network of progressive CPA firms, along with best-in-class professional advisors, service, and product specialists, who work together to deliver an elevated and holistic client experience. One that optimizes both their personal and professional lives with an integrated financial strategy designed to help clients reach their goals.