Income splitting in the TFSA era

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The practice of income splitting has been around for decades. Simply put, it’s the process of shifting income recognition from someone in a high tax bracket to someone in a low bracket. And, most often it’s carried out between spouses.

With the implementation of the tax-free savings account (TFSA) in 2009, another legal avenue has opened up for those seeking to reduce household tax costs. And the method works for the TFSA on its own and potentially in coordination with existing strategies.

Existing splitting strategies Tax authorities will often try to impugn aggressive splitting practices by attributing income apparently earned by a low bracket spouse back to one in a higher bracket.

Still, there are many common strategies that are allowed, and indeed encouraged, by our income tax laws:

• Second-generation income – Once income has been earned and recognized, further earnings on that income is taxable to the spouse who receives it. For this reason, one may choose to turn over such a portfolio more often in order to more quickly move into next generation income.

• Spousal loans – Income earned on money loaned from a high-bracket spouse to a low-bracket spouse will be taxed in the latter’s hands, so long as required interest is paid. Ironically, the recent economic downturn carried with it a positive twist for these kinds of loans, since the prescribed rate has been at its lowest calculated point of 1% for the last year.

• Fair market value exchanges – If a low-bracket spouse provides assets of fair market value equal to money provided by the high-bracket spouse, income earned on that money will be taxed to the receiving spouse.

• Pension income splitting – Since 2008, clients have been able to elect to have up to 50% of certain pension type income sources allocated and taxed to a spouse.

• Spousal RRSP – Contributions to a spousal RRSP may be withdrawn by that spouse and taxed to him or her in the third calendar year after last contribution. While taking care not to imperil later retirement needs, some of these withdrawals could be timed to coincide with a temporary low-income period experienced by the spouse, such as a sabbatical or maternity leave.

• CPP pension sharing – Spouses may pool and then split their pension credits in order to shift some of their entitlement and taxation to a lower-income spouse.

TFSA strategies A client is able to provide money for a spouse’s TFSA, and still have the growth in value of that TFSA belong to the spouse. And, when this is done there is essentially no income to be attributed. Doing this leads to a $5,000 non-attributable deposit that generates tax-sheltered income each year; and that figure is indexed to inflation every three or four years.

To put the value of TFSA contribution room in perspective, remember deposits to those savings vehicles are after-tax. For a rough estimate of how that compares to pre-tax RRSP room, divide by one, minus marginal tax rate.

So, a couple operating under a single income in a 45% bracket, their combined TFSA room equals about $18,000 as a pre-tax figure. In other words, they can nearly double the $21,000 tax sheltering room available under an RRSP alone in 2010.

And, TFSAs give receiving spouses a lot of options. For example, a receiving low-bracket spouse could pledge the TFSA as collateral to a lender in order to leverage invested assets. As the legal owner of the TFSA, all associated income would belong to the low-income spouse, and of course the interest charges should be deductible.

Arguably, the receiving spouse could employ the earnings from this leveraged strategy to assist in existing splitting strategies. For example, he or she could facilitate the eventual retirement of outstanding prescribed-rate loans.

Care, however, must be taken to assure that the particular steps do not cross one over into the TFSA advantage rules and/or fall within the purview of the General Anti-Avoidance Rule. Always ensure your clients are getting qualified tax advice before undertaking any steps that are more elaborate than plain-vanilla spousal TFSA contributions.

Regardless of a client’s income level, the TFSA rules offer one further advantage to spouses – the ability to name a spouse as successor account holder. At death, the account may roll to the survivor spouse, while having no effect on his or her TFSA room. Be aware, though, that any unused TFSA room of the deceased spouse is forever lost.

Accordingly, if a client becomes suddenly ill and the couple has to quickly move to making terminal estate plans, it may be prudent to fund-up a TFSA before death (and in some cases it may even be worth using a loan to do this). The loan, which can always be retired after account transfer following death, will help the surviving spouse preserve as much tax sheltering as possible.

(04/06/10)

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