In Canada, your income tax rate increases as you report more income. If your income falls into higher tax brackets, while your spouse or children have little to no income, your family faces a relatively high tax rate compared to the rate you would face if you all reported equal amounts of income. However, if you transfer some of your income to your family members, you effectively move your income into a lower tax bracket. There are several different ways to move income to family members, but you have to ensure you use a legal strategy.
Small Business Owners
If you own a business, you can lower your family’s overall tax rate by paying your spouse or children from the business. On the other hand, you may make your spouse a partner in the business and split the amount of self-employment income you report.
However, you may only use this strategy if your spouse or children actually work for your company. Additionally, the Canada Revenue Agency requires you to pay family members the same amount you would pay someone at arm’s length from you. As a result, you cannot claim your child earned $40,000 from your business or any other amount, unless that is a realistic amount you would have paid another person for doing the same work. There are other income transfer options.
Spousal Retirement Accounts
Contributions to registered retirement savings plans are tax-deductible. If your spouse earns less than you, you may lower your taxable income by contributing to your spouse’s retirement account. However, you cannot exceed your annual contribution rate. Even though you are contributing to your spouse’s retirement account, you only get to take your own contribution limit into account. You do not get to contribute your spouse’s limit as well.
This tactic will continue to lower your tax rate even into retirement. Once your spouse starts drawing on the retirement account, your spouse pays taxes on those earnings. If you had only contributed to your own retirement account, all of the earnings would be in your name and taxed accordingly.
Splitting Retirement Income
If you receive retirement income from an employer-sponsored registered pension plan, you may transfer 50 percent of those payments to your spouse. You can do this regardless of your age; it helps to lower the tax burden as long as your spouse earns less than you. Similarly, if you are over the age of 65, you may also split pension income from registered retirement and life income funds.
Family Loans for Investments
Use a prescribed-rate loan strategy to loan your family member money and charge at least 1 percent interest on the loan. Your spouse or child, in turn, uses the money to buy investments. When the investments earn money, your family member reports the income and pays the taxes rather than you. If you use this strategy, it’s important to understand the tax implications of income splitting. If your family member earns money that is classified as split income, that family member may have to pay top-bracket income taxes, which can undermine your efforts to lower your tax liability.