What is Income Spreading
Income spreading is a tax reduction strategy that is typically used by people with highly volatile incomes to reduce the overall marginal tax rate paid on a large sum of income. This strategy involves particularly large sources of income and dividing the amount realized over a period of years to reduce the overall amount of taxes paid. This tactic can also be used to avoid getting bumped up into a higher tax bracket, which would also in turn result in a greater tax liability.
BREAKING DOWN Income Spreading
Income spreading can be enacted in several different ways. The best option for a particular individual or business will depend on their specific circumstances and financial priorities. One way to implement income spreading is through an installment sale. This is when you sell a capital asset, and the terms of the sale dictate that the buyer will make payments in installments that are spread out over more than one tax year. This type of installment sale arrangement may allow the seller to report the capital gains from the sale over multiple years. Rather than realizing one major spike in income via a single capital gains occurrence, the seller can report a more moderate level of capital gain over a longer period.
Income Spreading Examples and Clarification
Professional sport stars and actors in the entertainment industry are examples of people who may want to employ some sort of income-spreading strategy to smooth out the volatility of their income streams.
Another use of non-retirement related income spreading in Canada is to place a portion of income into an RRSP and then withdraw the amount when the person decides to return for more schooling. Because RRSPs do not penalize people for withdrawing funds early if they are used for educational purposes, a person would effectively be paying less tax on the sum because, as a student, the person's marginal tax rate would be lower.
Income spreading is different than income averaging, although the basic principle is similar. Income averaging, which in the U.S. is currently available only to farmers and fishermen, allows a taxpayer to balance out the typical fluctuations of income in those industries. With income averaging, an eligible business can shift some of their income from the current year and shift it to the three prior years, which are known as base years. This tax averaging option gives those in the farming and fishing industries a way to help maintain a sort of balance in their tax obligations and offset the volatility that is common for businesses in those industries.