Equal Income for Retirement
By Arthur Drache
The two-income family is now more or less the Canadian standard. And, in the vast majority of cases, one of the two spouses earns significantly more than the other. From a tax planning perspective, it is much more attractive that investment income be earned by the lower-income spouse because that investment income will be taxed at a lower rate. The problem, always, is getting investment funds into the hands of that spouse.
There are actually two major problems. One is that the Income Tax Act is peppered with provisions (generally referred to as the income attribution rules) that limit the tax benefits of transferring money for investment to the low-income spouse. Indeed, a large part of personal tax planning is based on finding legal methods to circumvent these rules, ranging from loans at the prescribed interest rate to contributing to a spousal RRSP.
A second problem is more philosophical. Two-income families often view the sharing of expenses as a sign of "equality," with each contributing either half of the family expenses or contributions that reflect earnings in terms of percentages.
However, the philosophy that good tax planning involves putting investment capital into the hands of the lower-income spouse means tax savings. All tax planning should ensure that the lower-income spouse saves as much of his or her income as possible and uses that income for investment, while the higher-income spouse accepts that his or her savings as a percentage of earnings may be significantly lower than expected.
Happily, in the past couple of decades, family law rules have changed substantially. The main fear of past generations, the loss of capital on divorce, becomes meaningless since assets built up during marriage are split. In a nutshell, what it means is that if one is concerned about a future marriage breakdown, this fear should not be an impediment to income and capital splitting while the marriage exists.
Thus, the higher-income spouse should pay for all basic, non-deductible living expenses while the lower-income spouse saves as much of his or her earnings as possible and invests them. It may not sound "enlightened," but it is an effective way to ensure that the lower-income spouse has more investment capital.
We have seen this carried to greater extremes, where the parents of a couple have capital that they are prepared to lend or give, both inter vivos and by will, Saavy parents can lend money or make gifts, for example, only to their daughter-in-law for investment purposes, ensuring that the income generated will be taxable to her, not to their higher-earning son. (Loans work well here because the income attribution rules do not apply as they do between parents and children who are not minors.)
It is not unusual for grandparents to skip a generation by leaving large parts of their estate to grandchildren (subject to a trust) because their children don't need the capital, but this can also be extended to leaving that capital to a lower-income son-in-law or daughter-in-law. When such a gift is made, the rules with regard to a future splitting of the income should be reviewed to ensure that this capital is subject to division on divorce. In some provinces, this can be specified in the testamentary document.
As we come to tax return season, some obvious possibilities should be kept in mind:
- First, the higher-income spouse should, if at all possible, claim any expenses that are deductible.
- Second, any expenses that generate tax credits (medical costs and charitable donations come to mind) should be claimed by the lower-income spouse, though care should be taken that these do not reduce tax below zero and perhaps become wasted.
- Third, if the lower-income spouse actually owes tax (perhaps because the income-splitting planning is generating investment income), the higher-income spouse should pay the tax bill. This, again, is a transaction that amounts to a non-attributable transfer and helps preserve the lower-income spouse's income and capital.
The ability to do some tax planning simply by determining which spouse should claim a particular credit or deduction highlights the need for spousal returns to be done at the same time and preferably by someone who brings some level of critical thought to the matter. The returns should be done as early as possible, allowing the spouse who will get a refund to file early while the other spouse, if taxes are owing, files on or just before April 30.
These various steps are, of course, simply illustrative and those who think about the concept may find other ways to shift income and capital from the higher to lower-income spouse in their own situation. One may have the opportunity to pay a reasonable salary to a lower-income spouse for services provided. Or, if the lower- income spouse owns the family house, there may be the possibility of paying rent for a room that serves as an office. Such possibilities tend to come to mind when one looks at a particular situation.
While some of the techniques, such as those related to tax return preparation, may offer almost immediate benefits, others such as a shift in non-deductible spending take time to start paying real dividends. But whatever approach is used, the key to the whole plan is to ensure that the funds that accrue to the lower-income spouse are in fact invested, not just frittered away. If the money shifted is simply used to pay for an upscale vacation, for example, the exercise has become fruitless.
As with so many useful financial techniques, the key is self-control and a focus on the long-term goal. But properly handled, these approaches will produce major tax benefits over the long haul, with the big payoff at retirement when the couple will more closely approach the ideal of each having an equal flow of income.
Copyright 2002 by Arthur Drache. All rights reserved.
Arthur Drache is a partner in the Ottawa law firm of Drache, Buchmayer, LLP and specializes in all areas of personal tax and estate planning. The opinions and views expressed herein are those of the author and not those of CI Investments Inc. CI Investments Inc. does not necessarily endorse or encourage any specific tax strategies. Please consult a tax professional for advice specific to your particular situation.