DEFINITION of Income Splitting

Income splitting is a tax reduction strategy employed by families living in areas that are subject to bracketed tax regulations. The goal of using an income-splitting strategy is to reduce the family's gross tax level, at the expense of some family members paying higher taxes than they otherwise would.

BREAKING DOWN Income Splitting

An example of income splitting is a higher income family member transferring a portion of his or her income to a lower income family member through some legal means, such as hiring the lower income family member and deducting the cost of the labor as a legitimate business expense. Although the family still earns the same amount of money, the overall amount of tax it must pay is reduced.

Another example is the transfer of tax credits from a lower income family member to a higher income family member. This can be done by transferring tuition credits from students to parents funding their children's post-secondary educations.

In Canada, an income-splitting technique can be used to reduce tax liability through Registered Retirement Savings Plan (or RRSP) contributions because money contributed to RRSPs is tax deductible. (RRSPs are special types of investment accounts designed to help Canadians save for retirement. To be eligible for an RRSP, participants must be under the age of 71, has contribution room, and files taxes with the Canadian government.)

A higher income family member can contribute to a lower income family member's RRSP, thus lowering the higher income person's overall tax liability and potentially moving the higher income family member into a lower tax bracket.

Income Splitting and Tax Deductions

Several tax deduction options are available to citizens in addition to the income splitting strategy. The two major categories are standard deductions and itemized deductions. In the United States, the federal government gives most individuals a standard deduction that varies by year and is based on the taxpayer's filing characteristics.

Each state sets its own tax law on standard deductions, with most states also offering a standard deduction at the state tax level. Taxpayers have the option to take a standard deduction or to itemize deductions. If a taxpayer chooses to itemize deductions, then deductions are only taken for any amount above the standard deduction limit.

When itemizing deductions, it’s important to keep in mind that there may be certain limitations on what you can deduct each year. The IRS sets a threshold amount for many deductions. It’s important to research these prior to filing so you don’t expect to pay less than you ultimately have to.