Income splitting redirects income to family members in lower tax brackets to take advantage of their lower tax rates, deductions and credits; thereby cutting a household's collective tax bill. The wider the difference in income and tax brackets between family members, the more tax-saving power income splitting has.

A splitting headache: the attribution rules

As good as income splitting sounds, tax laws don't make it easy. Policy makers are well aware of the revenue shortfall at stake and have put up barriers – the attribution rules – to limit income splitting.

These rules aim to discourage you from transferring or lending cash, investments or other property to family members to reduce income tax. If you do so, any income earned on that capital can be "attributed" back to you. The attribution rules can apply to income earned by your spouse or partner, as well as minor children, grandchildren, nieces or nephews.

Fortunately, there are legitimate ways of getting around the attribution rules and putting income splitting to work. It's important to recognize that tax rules can be complex and we're only covering the basics here. Be sure to speak with your advisor and get proper guidance for your situation.

Six ways to save with income splitting

1. Make an investment loan

Giving cash, investments or other property outright triggers attribution and you'll be liable for tax on any income those funds earn. The way around that is to lend instead. The trick, however, to avoid attribution on an investment loan is to set an appropriate interest rate. The government has established a "prescribed" rate for this purpose, currently pegged at 1%. Make the loan at the prescribed rate or higher, and any investment income earned will be taxed in your family member's hands instead of yours. Loan interest must be paid within 30 days from the end of each calendar year.

If you decide to gift property or make an interest-free loan, the attribution rules do have a silver lining. Only first-generation income, or the income earned on the original capital, will be taxed in your hands. Any second-generation income, or "income earned on income", remains taxable in your spouse's or child's hands. In time, the effect of compound interest can grow second-generation income to a sizeable sum, overshadowing the cost of attribution.

2. Have children invest for capital gains

While investment income earned by minor children on property you give or lend can be attributed back to you, capital gains are not. So focus your child's investments on choices that don't distribute much current income, but offer the potential for capital gains instead.

For example, growth-oriented investments can be an appropriate choice to split income with your children since they distribute mostly capital gains. Your child isn't likely to have much other income, so these distributions are essentially tax-free.

3. Give to adult children to invest

While you can't give property to your spouse to invest and avoid attribution, you can give cash, investments and additional property to other adult family members.

Here's how gifting can create more after-tax income. Say your child's turned 18 and has only a small income from a part-time job. By giving them enough assets or cash to invest on their own, they can take fuller advantage of available tax deductions and credits which might otherwise go unused. In the end, they'll have more after-tax income to reinvest or pay for expenses than if you had invested the funds, paid tax, and then given the money. Gifting also shrinks your capital base so you'll have less taxable investment income in future years.

Supporting your adult kids with a down-payment for a new home, paying their tuition fees or covering your aging parents' living expenses are more ways you can contribute to your family's financial well-being without fear of attribution.

4. Have the higher earner pay the bills

Sharing household expenses with your spouse equally might feel like the right thing to do, but if you make a lot more than they do, it's poor tax planning. A smarter move is for you to use your income to take care of the bills and leave your spouse's earnings to generate investment income that's taxable in their hands.

Paying your spouse's taxes or helping them pay off consumer debts like car loans will further increase the cash flow available to invest. Because the money you're using isn't creating income directly, there's no attribution.

5. Make use of tax shelters

Popular tax shelters can help you achieve income splitting and often create tax benefits that will be realized later on.

If your spouse will have little pension income or retirement savings, contributing to a spousal RRSP is an effective income splitting option that's not affected by the attribution rules. By building your spouse's retirement assets you can come closer to equalizing your future retirement incomes and wind up in the same tax bracket, minimizing your joint tax bill.

Registered Education Savings Plan contributions grow tax-sheltered until the money's needed. The plan's growth will be eventually taxed in your child's hands as the RESP beneficiary, so there'll be little or no tax payable.

Once you've maximized your own Tax Free Savings Account contributions, you can still shelter more of your family's wealth in the future by putting up to $5,500 a year into your adult child's or spouse's TFSA without attribution.

6. Share pension income

The right retirement income splitting strategy can boost the payoff a retired couple receives from numerous government benefits and tax credits. Pension sharing is an important part of the mix. Under pension sharing, up to half of your income that's eligible for the pension income tax credit can be transferred to your spouse or partner for tax purposes annually. What qualifies as "eligible" pension income depends on your age. If you're under 65, registered pension plan benefits are the key source. After that, RRSP, RRIF and deferred profit sharing plan payments also qualify.

While Old Age Security (OAS) benefits don't qualify, CPP payments can be split under their own special rules. If you and your spouse are receiving CPP, you can elect to split your payments equally. If you alone are receiving CPP, you can choose to shift half of your payment amount to your significant other. Unlike pension sharing where each year you decide how much of your pension income to share, if any, the CPP decision is a one-time election that stays in force.

If you're in a higher tax bracket, diverting some of your pension income to your spouse can lower your joint tax bill.

First, the income that goes to your spouse will be taxed at their lower marginal rate. You can also potentially double the pension income tax credit to $4,000, since your spouse will now have more income to use up the credit. Fully using the pension credit means a couple in a 30% tax bracket would each save $600 in taxes.

For those with substantial retirement income, there’s the OAS "clawback" to be aware of. Each year, the government sets an annual income threshold that if you exceed, you'll then have to repay 15% of your OAS benefit. If your net income hits another mark, you lose your OAS altogether. Shifting pension income to your partner can reduce your income and pull you back from these two thresholds.

Is it always worth it?

Income splitting can pay off in tax savings. But is it always worth doing? Here are some factors to weigh.

Compare tax brackets. If you and your spouse are already in the same or similar tax brackets and there are no other family members to split income with, there's unlikely to be much benefit.

Expect the unexpected. Shifting part of your tax obligation to other household members might create tax consequences you don't expect. For example, will freeing up cash to give your adult children require you to sell assets triggering taxable capital gains? Or, does bumping up your spouse's pension income suddenly subject them to the OAS clawback or cause the loss of tax credits?

Consider the paperwork. Properly documenting your income splitting efforts is essential, but opening separate bank or brokerage accounts to track income, drafting up loan agreements or creating promissory notes can be an administrative burden. Figure out if the tax savings will be worth the effort.

Change of ownership. Gifting assets can mean losing control over the property you give. Be sure you're comfortable with the implications of that before you go ahead.