Slash taxes…and add thousands to your family budget

My 19-year-old daughter Laura had a taxing epiphany last summer. Fresh from her first couple of weeks at her summer job as a receptionist at a local hair salon, she waltzed in the front door, sat herself down at the kitchen table and ripped open the envelope holding her first paycheque. Her initial giddiness quickly turned to shock. She had worked 40 hours at $10 an hour. That totaled $400. But her paycheque amounted to only $344. Where was the rest of her money?

After a brief talk about how taxes work, I told her the good news—that our family was using several tax and income splitting strategies to make sure we weren’t paying a dime more in tax than we had to. In fact, she was benefitting directly from one of our strategies: the Registered Education Savings Plan (RESP) that her dad and I set up to help her pay for university or college. With an RESP, I explained, she was not only the beneficiary of her parents’ largesse, but also the government’s—since the feds throw in an annual cash grant. Even better, when we withdrew that money, we would pay very little tax on it, because it would be taxed in her hands, not ours. Her reaction? Of course, she wanted to know more.

My experience with Laura reinforced how much interest there is out there among families who want to save on taxes and increase their net household income. Most of us are willing to pay the taxes we have to, but no one wants to overpay. The truth is, the tax man has carefully eliminated almost every loophole out there, so you should take full advantage of the very few strategies left to slash your tax bill. And one of the most effective is income splitting.

Anything you can do to distribute the income your family earns as evenly as possible among all family members will save you big money at tax time. When you use income splitting, you’re taking as much money as possible from the higher-income earners in the family and making sure it’s taxed in the hands of the lower-income earners, whether that’s your husband, wife or the kids. Why do you want to do that?

Because the higher the income of any one person, the higher the percentage that goes to taxes. If one spouse living in Ontario earns $100,000 on her own, she’ll pay about $31,000 a year in taxes and government benefit payments. But if you could split that income evenly between both spouses, you pay only $24,000. Same overall income, but much lower taxes: You’ll save $7,000 each and every year.

The government doesn’t like you doing this, of course, even though in many other countries, such as France, it’s expected that a family’s income should be evenly spread among the family members who live off of it to reduce taxes. So in Canada, we have attribution rules that try to force you to pay the tax rate of the higher-income earner, even if he or she gives the money to lower-income earners in the family. Luckily, there are several clever ways to get around the attribution rules—and they’re all perfectly legal.

The most popular way to split your income is with your spouse. The bigger the difference between your incomes, the more money you stand to save. In each case, the goal is to take as much income from the highest earner as possible, and have it taxed in the lower earner’s hands instead. Here are the most effective strategies.

Invest in the lower earner’s name
Most couples pool their income and pay for their household expenses out of the combined total. But you can save a lot on taxes if you have the higher income spouse pay for all the family bills and expenses so the lower-income spouse can make the investments. That means that all of the interest and capital gains from those investments will be taxed at the lower tax rate of the lower-income earner.

Collin Forbes, 35, and his wife Jennie Thorner, 33, of Vancouver have been using that strategy for several years now. The couple has been using Forbes’s $70,000-a-year salary as a psychiatric nurse to pay for all the household expenses while Thorner’s $30,000 salary as an on-call elementary school teacher goes towards investing. For example, four years ago the couple took Thorner’s savings and bought a small rental condominium on the outskirts of Vancouver. Any investment income from the property is taxed in Thorner’s hands, not Forbes’s hands, which means a much lower tax rate. “We plan to hold on to the condo for the long term,” says Forbes. “Our numbers show we’ll start making money in four years. At that time, any money the property makes will be taxed at Jennie’s much lower tax rate. We’ll come out ahead.”

Loan money to your spouse
Yes, it sounds strange. Why would you lend money to your husband or wife? Well, when you’re dealing with a tax system that taxes you as individuals rather than a family, it can lead to some rather peculiar behaviour. This is a variation on the above strategy, but in this case, rather than the lower-income spouse buying the investments with his or her own money, the higher-income spouse lends money to the lower-income spouse, who then uses it to buy the investments. As before, that means the investment income is taxed in the hands of the lower-earning spouse, at a much lower rate.

The catch is that this has to be a proper loan. That means a promissory note should be written up all official-like, with the interest rate and principal amount specified. It also means that the spouse borrowing the money has to pay interest. How much? “The government sets the prescribed rate every quarter,” says Allan Madan, a chartered accountant in Mississauga, Ont. “Right now, however, it’s at an all-time low. Taking advantage of the 1% interest rate on spousal loans is the No. 1 tax-planning opportunity for couples. So as long as your spouse can earn more than 1% on his or her investments, then this is a good strategy.” Just don’t miss a payment: If you do, the loan will be deemed invalid and the interest and capital gains on the investments will revert back to being taxed in the higher-income earner’s hands.

Set up a spousal RRSP
The usual strategy is to set up a spousal RRSP account in the name of the lower-earning spouse, and have the higher earner make the contributions. The higher-earning spouse doesn’t have to pay any taxes on the money he or she contributes, and when the money is withdrawn, it will be taxed in the lower-income spouse’s hands at a lower rate.

Spousal RRSPs are generally intended for splitting income in retirement, but you can make withdrawals from spousal RRSPs at any time. So it might pay to make a prudent withdrawal from a spousal RRSP at such times during your life when your family really needs the extra money.

That’s what Margaret Malicki, 37, and her husband Roman, 43, found out two years ago when Margaret, a stay-at-home mom in Georgetown, Ont., stumbled across an income-splitting strategy on a tax planning website. At the time, Margaret was at home with her two young daughters and earned no income of her own. Roman, on the other hand, was the main breadwinner and earned a six-figure salary. “I didn’t want to miss any tax-saving opportunity for us that year,” says Margaret. “It was just one line on spousal RRSPs and the attribution rules for withdrawal, but that one line got me thinking.”

After running the numbers on her personal tax software program, Margaret, a former bookkeeper, decided to make a one-time $50,000 withdrawal from her regular RRSP. Because she wasn’t working, she knew that withdrawal would be pretty much her only income for the year, so she wouldn’t pay much tax on it. By withdrawing the money when her income was low, she figures she saved $6,000 in taxes. (She did however have to pay a “withholding tax” of $15,000 on the withdrawal, so she initially only got $35,000. She was able to claim most of the withholding tax back when she filed her taxes.)

Last February, Roman then contributed $50,000 into Margaret’s spousal RRSP. In 2013 she will withdraw that $50,000, and when she does, because her income will otherwise be zero, she’ll again pay very little in taxes, so they’ll save yet another $6,000. Margaret’s only regret? “That I didn’t do it earlier,” says Margaret. “I could have done it years ago when my children were just babies and saved even more.”

If you plan to use this strategy, be aware that the Canada Revenue Agency (CRA) insists that you leave the money in the spousal RRSP for up to three years after the higher-income spouse has made a deposit, otherwise, it’s taxed in the higher earner’s hands. In this case, that means that no contributions can be made by Roman to Margaret’s spousal RRSP in the calendar year she withdraws the money, or either of the two previous years.

As well, keep in mind that the amount you contribute to your spouse’s RRSP is subject to your own RRSP deduction limit. In other words, the total combined contributions to your own RRSP and your spouse’s RRSP cannot exceed your limit.

Tax-free cash to buy your home
If you’re familiar with the Home Buyers’ Plan (HBP), then you know that if you and your spouse are first-time home buyers, you can make withdrawals for the down payment on a principal residence from your RRSPs. That means that both you and your spouse can withdraw up to $25,000 each tax-free—and all without withholding taxes. This strategy works particularly well in situations where one spouse has little or no income. That’s because the spouse who is working—if he has the RRSP contribution room—can contribute $25,000 to his own RRSP as well as $25,000 to a spousal RRSP, effectively doubling the amount a couple can withdraw for a home purchase.

This is all good news. But Michael Rutherford, 40, and his partner Maurice Debellis, 52, of Toronto, found a way to get even more tax-free savings. (We’ve changed their names and other details to protect their privacy.) Rutherford, a department manager with a wireless phone company, earns $100,000 a year. His partner, Debellis, has no income. The two want to buy their first home. So two years ago, Rutherford opened a spousal RRSP account in Debellis’s name and deposited $25,000 into it. This coming year—after the required three-year waiting period—Debellis, who has no other income, will withdraw that money practically tax-free, because that $25,000 will be his only income that year.

Soon after, Rutherford plans to deposit another $25,000 in Debellis’s spousal RRSP. Since there is only a 90-day wait before money can be withdrawn from an RRSP when used for the HBP, Debellis can withdraw the money from his spousal plan tax-free when they’re ready to buy a home. Rutherford will do the same—withdrawing $25,000 from his own RRSP. That means they will have a total of $75,000 to put towards the down payment—all of it virtually tax-free. “We’ll use all the money to buy a home in both of our names,” says Rutherford. “With house prices in Toronto being as high as there are, every little bit helps.” Rutherford and Debellis will start repaying the $25,000 to their RRSPs starting the second calendar year after the withdrawal to buy the home so that no money is ever taxed.

Raising kids is expensive, so it’s nice when you can use your kids to actually reduce your costs for a change. How can you do that? Income splitting. Most families already do some basic income splitting with their children by simply depositing their child tax benefit cheque in a bank account in the child’s name. Income earned on those funds is taxed in the child’s hands. Here are some ways to save even more.

Give cash to your toddler
Income or property transferred or loaned to your children if they are under 18 will almost always be attributed back to you. So you’ll pay the tax on any dividends and interest earned on that money at your regular rate. However, that’s not the case with capital gains. Let’s say you give your three-year-old $100,000 and use it to buy shares of some growth companies in her name. By the time she’s 18, those shares could be worth $200,000. She could then withdraw $20,000 a year, and pay the capital gains taxes on that growth at her own much lower tax rate. “The younger the child the better,” says Madan. “It means more time for the capital gains to compound.”

Gift cash to your adult kids
Money or assets given to a child who is 18 or over don’t result in income attribution back to the parents at all, so the above strategy works even better. The only thing to watch is that you should usually give your kids cash, not stocks or other investments. That’s because when there’s a transfer of ownership, a “deemed disposition” takes place, and you will end up paying taxes on any capital gains just as if you had sold your assets, be they stocks, bonds or property.

Contribute to your child’s TFSA
Rather than just giving your kids money, you can put up to $5,500 a year in your adult child’s Tax-Free Savings Account, or TFSA. The tax consequences are the same as any other cash gift, except that if the money is invested, then it will compound tax-free in the account, and your child won’t have to pay any taxes at all on any capital gains or investment income when he or she withdraws the money.

Pay for your kids’ education
Setting up a Registered Education Savings Plan (RESP) for your kids lets you save on taxes in a couple of ways. Your contributions aren’t tax deductible, like RRSP contributions are, but the investment earnings do accumulate on a tax-deferred basis. As well, the federal government will pay a Canada Education Savings Grant (CESG) into the RESP. Then, when your child starts post-secondary schooling, funds can be withdrawn practically tax-free because RESP investment earnings and government grants will be taxed at your child’s low marginal tax rate. “My husband and I contributed $2,500 to our son Solomon’s plan so we could get the maximum $500 annual government grant for him,” says Michelle Cornish, a 36-year-old accountant in Enderby, B.C. “We plan to do that every year. Post-secondary fees keep climbing so we really want to help him out.”

Income splitting works at any age, but once you retire and start collecting government benefits such as Old Age Security, it works even better. Many social benefits are income tested so splitting income may help the higher-income spouse reduce her taxes and get more benefits. Take the Old Age Security clawback. If your income exceeds $67,668 in retirement, you must begin repaying part of your OAS back to the government. Once your income hits $109,607, then all of your OAS is taxed back. Transferring income to a lower-income spouse can help you keep more of your benefits. Here are a few more strategies for pensioners to consider.

Share your CPP
In order to share their Canadian Pension Plan (CPP) benefits, both partners must be at least 60 years of age and both must be receiving CPP. (If only one of you receives CPP, then you always share that one pension.) If you meet both these requirements, the higher income spouse can elect to attribute up to 50% of his or her CPP income to a spouse. The arrangement only ends if you and your spouse separate or divorce, or when one of you dies. “You can optimize the amount that you split,” says Madan, the tax expert. “An accountant can do the calculation for you and submit the appropriate forms to the CRA.”

Share other types of retirement income
Since the 2007 taxation year, individuals have been allowed to allocate up to one half of their pension income (apart from CPP) to their spouse. Prior to this, only CPP could be split. Eligible “pension income” for splitting includes income from a registered pension plan, registered retirement income fund (RRIF), or annuity payments from an RRSP. (Retiring allowances, RRSP withdrawals other than annuity payments, and death benefits can’t be split.)

To give you an idea of how much money can be saved, consider a couple where the lower earning spouse earns $15,000 and the higher income spouse earns $85,000 (with eligible registered pension income, CPP and OAS). If this couple splits their income so both are earning $50,000, the annual savings would be just over $3,000 per year (including both the income tax savings and the reduction in OAS repayment for the higher income spouse). The exact number would fluctuate, depending on what province you live in.

We hope we’ve shown you how a little planning can save your family thousands of dollars. If you’re intrigued by the above suggestions, consider doing your own research. A few strategies we didn’t go into here but may be worth considering include swapping assets with your wife, third-party loans and transferring property to your children. Just remember, before implementing any strategy consult a tax expert. It’s better to spend a bit of money up front for an expert opinion than to spend thousands later in taxes or penalties because you forgot to fill out a form or missed a deadline.