How income splitting works and who does it work for: some practical examples

Income-splitting works by allowing families to allocate more of their earned income to a lower tax bracket by sharing the earned income between the spouses when filing taxes. The maximum amount of income that can be split this way is $50,000. Income-splitting makes a difference to a family’s tax bill because we have a progressive income tax system — the more you earn, the higher your tax rate is. For 2011 tax year, Canada has the following federal tax brackets (from CRA):

So if one parent earns $70,000 and the other parent stays at home to look after the kids, under the current system the family pays the lowest 15% tax rate on the first $41,544 of their earnings and 22% on the next $28,456. With income splitting, the family can declare that each parent earns $35,000 (i.e., they split the income), which puts both parents into the lowest tax bracket. So the family pays 15% tax on all of the $70,000 of earnings, saving the difference in the tax rates between the bottom and the second tax bracket — 7% — on those $28,456 that would have fallen into the second tax bracket.

$28,456 x 0.07 = $1,991.92

This is rounded to $1,992 in the Conservative Party’s backgrounder on the issue.

Similarly, we can calculate the savings from income splitting for a family where one of the parents earns $60,000 and the other earns $20,000 (the other Conservative example). Under the current system, the family pays 15% tax on the $20,000 earned by one of the parents and on the first $41,544 earned by the other parent. The family pays 22% tax on the remaining $18,456 that the higher income earner brings home. With the proposed income-splitting, the family would share the income between the two parents, each reporting $40,000. This puts them in the lowest tax bracket, so the entire family income of $80,000 gets taxed at 15%. The family saves 7% tax on the $18,456 that would have fallen into the second tax bracket.

$18,456 x 0.07 = $1,291.92

This is rounded to $1,292 in the Conservative Party’s backgrounder on the issue or $1,300 in Stephen Harper’s announcement of income-splitting on March 28th.

Of course, neither Stephen Harper nor the backgrounder mentioned that families with single earners in higher tax brackets get more than that.

In fact, the highest possible benefit goes to the few families with a single earner whose taxable income falls at least $50,000 above the cut-off for the top tax bracket. With the current tax brackets in Canada, this means a family with a stay at home parent and an earner who brings home $178,800 or more per year — a doctor or a lawyer perhaps, or a business executive.

This family will be able to allocate the maximum allowable $50,000 towards the income of the stay-at-home parent. Instead of having these $50,000 taxed at the hands of the earner at the highest bracket rate of 29%, they would be taxed as follows: at the bottom rate of 15% for the first $41,544 and at the second lowest rate of 22% for the next $8,456. This will save the family 14% of tax on the first $41,544 and 7% on the next $8,456.

$41,455 x 0.14 + $8,456 x 0.07 = $5,816.16 + $591.98 = $6,408.08

This is the maximum possible benefit from the proposed income splitting under the current tax brackets.

Of course, the 2 million single-parent families in Canada will get no benefit from income splitting, as there’s no spouse to split the income with. Dual-earner families with spouses who earn equal incomes will also get nothing. Single-earner families with an earner whose taxable income falls in the bottom tax bracket (currently under $41,544) get nothing. And among families with a stay-at-home parent or a parent working part-time only, the higher the salary of the working parent, the higher the benefit.

Now that you know how to do the calculation, how much would your family get from the proposed income splitting?

Does this sound like a good way to spend $2.5 billion of our taxpayers money?

For my take, see this earlier blog post.

Topics: Economy, Poverty, inequality & welfare, Taxes, Women