Income splitting is a process where taxable income is intentionally reduced. The purpose of this reduction is to decrease tax liability. This strategy is used in places where tax burdens increase as income moves into higher ranges.
In many locations there is progressive taxation, which means that as people earn more money they are required to pay more taxes. This leads many individuals to try to find ways to reduce the amount of income that is considered taxable so they can also reduce their income taxes. Income splitting, which is a process where individuals move money between them, is one way of doing this.
Income splitting is likely to be most popular and effective in places where members of a family are allowed to file individual tax returns. In some places, a couple is required to file a joint income tax return. This means that each spouse’s earnings are not viewed separately. Instead, their income is combined and viewed as a whole for tax purposes, meaning their taxable income will be in the same tax bracket regardless.
A couple in a place where married people can file separately, however, may save large sums of money if the spouse with the highest income transfers enough funds to his spouse that he descends into a lower tax bracket. In some countries, it may be illegal to blatantly allocate money this way for the purpose of avoiding income taxes. This does not mean that there are not legal ways to accomplish the task. For example, a working husband may pay funds into a tax deferred retirement account on behalf of his wife. If this account is only taxable upon withdrawal of the funds, he will not be liable for income taxes when the money is earned.
Families are not the only ones who can benefit from income splitting. This strategy can also be used to reduce corporate taxes. If a person owns a corporation, he may be able reduce the business’ tax burden by paying out money to himself and his spouse as salaries. Income splitting may involve some individuals paying a higher level of tax than they otherwise would. If the total tax burden is considered, however, the amount paid should be less, and then the strategy can be considered successful.
When considering the savings that will be provided by income splitting, the costs must be considered. If a family does not prepare their own taxes, for example, then it is likely that each individual’s taxes will be subject to preparation costs. Likewise, when splitting income from a corporation, both business and private accounting costs must be considered.