Thursday, February 28, 2008

Tax-Free Savings Accounts (TFSAs) and Income Splitting

The Big Cajun Man over at Canadian Personal Finance has been calling for tax relief for single-income families for some time now. One way the government could do this would be to permit income splitting.

Consider a hypothetical couple, Carol and Dan. Carol earns $80,000 per year as a software developer, and Dan stays home with the kids earning no income. Most people publicly praise Dan for taking on a non-traditional nurturing role while privately wondering what’s wrong with him. It takes a long time for attitudes to change, but that’s another story.

Carol gets some tax breaks for supporting a spouse, but she still pays a lot in income taxes. If the Canadian government permitted income splitting, she and Dan could each declare $40,000 per year in income, and their overall tax bill would be quite a bit lower.

We’ve heard that the Canadian government’s new tax-free savings accounts (TFSAs) provide income splitting opportunities. However, you will not get the same immediate benefit as real income splitting as in the example of Carol and Dan.

Carol can put money into Dan’s TFSA, and he can take it out sometime in the future tax-free. Of course, she can take money out of her own TFSA tax-free as well. Any lowering of taxes will happen in the future, unlike real income splitting which gives tax benefits right away. This strategy is similar to using spousal RRSPs.

A better way of thinking of this is that Carol is able to shelter $10,000 of her savings per year because she is married to Dan. If she were single, she could only shelter $5000 of her savings per year. Of course, this only matters if she and Dan are able to save $10,000 per year on top of their RRSP contributions.

Most families will not be able to make the maximum contribution to both their RRSPs and TFSAs. This means that they will not get any additional income splitting benefit from TFSAs. Don’t let this sour you on TFSAs, though. They will be of great benefit to people who save for the long term.

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