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22.  Income Splitting (SPLITS) and International Investing Thumbnail

22. Income Splitting (SPLITS) and International Investing

Welcome to Episode 22 of Retire Me!  

Income Splitting:

I often get asked about how you can effectively split income with your family.  It is common for a family to have either a single income earner, or a disparity between the incomes of a dual income household.  Regardless of whether you are retired or not, there are a number of perfectly acceptable and above-board ways that you can split income with your lower-income family members.

To help you remember some of the steps, I use the acronym SPLITS.  (thank you to Gail Drory from York University for the help on this one :))

Today we welcome back our hypothetical couple, Sue and Dave, to help us through the income splitting scenarios that we discuss in the episode.  

Hypothetical Couple - Dave and Sue

  • Sue is an entrepreneur (sole proprietor), she makes $250,000 per year in income after her deductible business expenses

  • Dave is working part-time and nearing retirement, he makes $80,000 per year 

  • They have 2 children, twins, age 25

Here are the 6 steps that Dave and Sue can take to split income

S - Spousal RRSP's

  • Sue can contribute to a spousal RRSP in Dave's name
  • Sue is in a higher tax bracket than Dave, so it makes sense for her to use up her RRSP contribution room for the immediate tax reduction
  • Spousal RRSP contributions come off of the contributing spouses income in the year they are contributed, though the funds in the Spousal RRSP effectively become the property of the spouse, Dave in this case
  • As long as Dave leaves the funds in the Spousal RRSP for over 2 years, any future withdrawals will be taxable in his hands, presumably at a lower rate than Sue, which has an income splitting effect
  • This strategy is effective for retirees who anticipate being in a higher income tax bracket in retirement and want to make early withdrawals from their RRSP's to avoid this situation
  • In Sue and Dave's case, they will be better off having Dave make those early withdrawals if they become necessary.  Dave is in a lower income tax bracket than Sue.

P - Pay the Bills 

  • Sue should pay the bills in their home and leave more funds for Dave to invest in his name
  • Assuming that they have maxed out their RRSP's and TFSA's (and even paid down their mortgage), any additional investment funds would likely be in non-registered or taxable accounts
  • Since Dave is in a lower income tax bracket than Sue, capital gains, interest, and dividends would be taxed less in his hands than in Sue's hands between now and retirement (assuming that their earning patterns remain intact)
  • This is an effective way to even out their taxes and get more after-tax investment income between now and retirement, achieving an income splitting effect

L - Loans at Fair Market Value

  • Sue can issue a loan to Dave so that he can invest funds
  • In the absence of a loan, any investment gains made on money she gives Dave will be taxable in her hands- this is also called "attribution" in the words of the CRA
  • If Sue loans Dave money to invest (and that loan is within the CRA guidelines), the income from investments will be taxed in his hands.  Presumably, this will be at a lower tax rate than Sue at the time the income is realized - creating an income splitting effect

I - Income on Income

  • If Dave and Sue forget to put their loan in place, they can still achieve an income splitting effect 
  • If Sue gives Dave money to invest, the income that is generated by the original gift is taxable to Sue
  • But the "growth on the growth" is taxed in Dave's hands, creating an income splitting effect as long as Dave remains in a lower tax bracket
  • Over time, his income on the growth could outpace the income on the loan that gets attributed back to Sue
  • I use, as a simple example, a GIC paying 2% per year (compounded).  For higher risk investments (ie. stocks and bonds) the impact would hopefully be higher in the long run.  See below:
Beginning of Year ValueGrowth (2%)End of Year ValueIncome to SueIncome to Dave

T - Tax Free Savings Accounts

  • Sue can fund Tax Free Savings Accounts for Dave and also for her twins
  • While investment income from cash gifts get attributed back to Sue for her family members, this is not the case when the funds are contributed to a Tax Free Savings Account
  • In this way, the income generated for Dave and the twins from Sue's income becomes a form of income splitting - creating tax-free income on TFSA investment growth

S - Salary

  • Sue can pay her family members a reasonable salary for working in her business
  • So, Sue could pay the twins to work at her company
  • The salaries are deductible business expenses to Sue's business (reducing her taxable income) and the salaries are taxable income to the twins who are in a lower tax bracket than Sue - this creates an income-splitting effect
  • With all of these strategies, it is important that you review them with your accountant and keep accurate records

Key Questions for the Long Term Investor - Is International Investing For Me?

Today, we examine the question - Is International Investing for Me?  In my opinion, international investing is a great way to both enhance your returns and lower the "bumpiness" in your portfolio ride (volatility).

In a blog from the Rational Reminder , they discuss 3 main reasons to diversify globally

  1. There is a world of opportunity outside of Canada - Canada makes up less than 3% of the world's equity market capitalization but Canadians disproportionately hold Canadian securities in their portfolios.  Canadians, on average, hold over 60% of their portfolios in Canadian companies.  If you hold most of your equities in one country, you expose yourself disproportionately to the fortunes of that country's long-term economic performance.
  2. Returns are like lightning strikes - most of the net wealth creation of stocks over bonds come from a tiny subset of stocks.  Authors of the 2019 paper Do Global Stocks Outperform US Treasury Bills? found that a mere 1.3% of global stocks explained the net wealth creation in global stock markets from 1990–2018.   Being diversified is the best way to ensure that you participate in the growth of markets.
  3. The Whole Is Stronger Than Its Parts - adding international equities to a portfolio tends to decrease volatility risk and increase expected returns

I examine the returns of several portfolio's to illustrate the impact of international investing for a Canadian equity investor, and a Canadian Balanced investor.  For both investors, the addition of international stocks and bonds both increased the portfolio's performance and decreased it's volatility (as measured by standard deviation).

Full report with disclaimers and index construction are DFA Returns Web Report - Episode 22

Thank you for listening!


Disclaimer - This podcast is for informational purposes only.  Please consult with a financial advisor familiar with your unique financial situation before making any decisions.  Nothing in this broadcast constitutes a solicitation for the sale or purchase of any securities.  Any mentioned rates of return are historical or hypothetical in nature and are not a guarantee of future returns.  Mark Walhout is the owner and lead financial advisor at Walhout Financial and an Investment Fund Representative at Investia Financial Services Inc.