Sunday, February 16, 2014

A Taxing Issue - Income Splitting



Income Taxes Are Probably Your Single Largest Expense - Do you have any idea how they work?

This article will be written with a Canadian slant, but some of these principles may apply in other countries. This information is also provided for entertainment purposes only, I am not an accountant or a lawyer. This is general information, and does not constitute specific advise to you.

Do you think of yourself as a diligent shopper? Do you shop around for the best deal when buying home electronics? Do you consult gas station websites before filling up? Do you search for coupon codes before buying things online? Do you use look at flyers and use coupons when buying groceries? Are you someone who "never pays full retail" and is proud of it?

You may be doing all of these things, but completely failing to try to save any money on your largest expense, income tax.

Current and previous year Canadian tax rates are listed here. For those who don't know how taxes work, you are taxed at different rates depending on how much money you earn. Everyone is given a basic credit, to offset these taxes, and there are additional credits for children, etc.

Using a simple calculator, assuming only the basic exemption applies, living in Ontario, here are some estimated taxes:


IncomeIncome TaxAverage Tax RatesMarginal Tax Rate
$40,000 $5,892 15%24%
$60,000 $11,873 20%31%
$80,000 $18,300 23%35%
$100,000 $26,600 27%43%


If you were a business, would you ignore an expense this large? Given the dollars involved, isn't it worth reading at least one tax book or finance blog (written by an accountant)?

OK, So This Is Worth Looking At - What is Income Splitting?

Before we get into this, if you're single, you can ignore this. I do promise to write more tax tips, some that might apply to singles.

As you can see from the table above, the more money you earn,  the higher percentage tax you pay. The "Marginal Tax Rate" is the rate of tax you pay the next dollar you earn. So, in our example, if you earn $100,000 in Ontario, and you earn an extra $1, that $1 is subject to 43% tax (so earning $1 only gives you $0.57 to take home).

If you're married, or in a common law relationship, whoever earns the most money is paying the most taxes and has a higher marginal tax rate.Where this really matters, is if you can arrange any extra income (such as investments) to be taxed in the hands of the lower income person. The difference between investments being taxed at 43% or 24% is significant. This obviously comes more into play with a household that has a $100,000 earner, and a $20,000 earner than a household with two $30,000 earners, but it's unlikely both spouses earn exactly the same income.

So Why Can't I just Write A Cheque To My Spouse?

Because this is such a great way to reduce tax, the government has laws called "attribution rules", which prevent this. If you earn money, and give it to your spouse to invest, then YOU (who earned it) must pay the tax on the investment income. This also applies if your earned income comes into a joint account, and your spouse happens to draw from that account to invest.

There are also rules that relate to giving your children money, and who pays the tax on income it earns.

This is Too Complicated

I agree, if you've read this far, congratulations. Between some of the different strategies on taxation, etc., this does get kind of crazy. So I'll try to keep this simple. This post should give you some ideas, but you should definitely do some further reading on your own.

The good news is, some of the best ways to legally split income are very simple.

Steps For Higher Income Earner:

Strategy 1: Max Out Tax Free Savings Account

Higher earner maxes out the contribution to a TFSA.

Before looking at other strategies, if you don't have a TFSA (Tax Free Savings Account) you should immediately go out and get one. The government allows you to setup investments, earn income on them and PAY NO TAX. There are limits to how much you can contribute into these separate accounts, but this type of account is a winner, and also simplifies the number of forms and receipts you need to have during tax time.

Savings: This type of account actually reduces the need to split, since the higher income earner can contribute $5,500 (as of 2014) into an investment account that earns no tax.

Strategy 2: Max Out Spouses' Tax Free Savings Account 

Higher earner contributes to spouses' TFSA.

As discussed earlier, if you give money to your spouse and they earn income from it, then you (who earned the money) must pay the tax on the income. This does not apply with a Tax Free Savings Account, since there is no tax earned on the money invested.

To avoid confusion, and potential tax implications, I wrote a cheque to my wife, which she deposited directly into the TFSA. This way, there is no doubt which money from me, went where.

Savings: Allows you to shield $5,500 (or so) per year from tax.

Strategy 3: Pay ALL Expenses From Higher Income Earner FIRST

Our family has successfully been doing this since marriage. Doing this doesn't require anything fancy, or talking to a lawyer or accountant or anything, but this does require a great deal of trust with your spouse, which hopefully you have already! Whoever is in the higher tax bracket pays absolutely everything, including discretionary expenses. If there are additional expenses, the lower income earner starts paying them only after the higher income earner is out of money.

I am in the higher bracket, so I pay all expenses. To make tracking things easier, we are both paid into our own separate accounts. While we did make these both joint (to make the money accessible to both of us in the event of one of us dying).

If it takes all of one income, and some of another to cover expenses, you can still execute this, just have the higher income earner pay all their money to expenses FIRST, and the lower income earner hopefully has something leftover for savings. If you have no money leftover for savings, you're on a treadmill you'll never get off...

Savings: Allows investments to be taxed at the lower spouse tax rate, rather than higher spouse tax rate

Strategy 4: Spousal RRSP


The government allows you to contribute to your spouses retirement savings. The investment grows under your spouses' name and when withdrawn, is taxed in your spouses' name.

We have setup a spousal account, and I have stopped contributing to my own account. I personally have some worries that when it comes time to remove the money from the account, the government will have raised taxes . Garth Turner, a financial writer and former Finance Minster, has some excellent points about pitfalls with an RRSP.  For this reason, I've listed it later. Many banks and investment advisors are always pushing RRSP's, it's really important for you to understand how taxes work yourself, and then you can see what really makes sense for you and what doesn't.

You can read about some of Garth Turner's reasons in favour of RRSP's here.

For my own household, being able to have income taxed across both of us in the future versus tax singly in my hands now is advantageous.


Savings: As much as 18% of income (up to a maximum) of higher earner is instead split 50/50 (ideally) between the two of you and taxed later.

Strategy 5: Talk To A Professional

If you've still go too much money in the hands of one family member, then you need professional help.

Conclusion:

What may make sense for you, may not be what I've written. Perhaps your employer matches RRSP contributions, in that case you would definitely want to take advantage of that. Perhaps you have a workplace pension, or a pension from your union. This can change strategy as well.

Different types of investments may go up or down, but understanding tax rules is guaranteed to pay off. For the amount of money you may be paying in taxes, shouldn't you have some idea how it works? and how best to (legally) reduce your taxes?

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