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Planning a Family? Prepare by splitting your income… with yourself?

A growing number of young people have put education and a career ahead of a family. In the past 20 years the average age of women having children has risen from 26.9 to 29.6 and many more men are taking leave to raise children. These changes in our society have made it where parents are earning higher incomes prior to having children.

So is there a way to transfer some of that high income to years when we are off work raising a family?

Is there a way to reduce the tax we pay and still receive maternity and parental benefits?

In Canada we pay a lot in income tax, but we also receive a lot in social assistance. Through our Employment Insurance program mothers are entitled to 15 weeks maternity benefits and parents are entitled to 35 weeks parental benefits. You may receive a maximum of $21,500 or about $1790 a month. To someone earning $70,000 a year, that is a significant pay cut!

So what can you do? à Split your income!

Income splitting is a strategy that allows you to shift your income from high income years to low income years, thereby reducing the overall amount of tax you have to pay.

The way this works is that you make RRSP contributions in the years before you start a family, thereby reducing the tax you pay in those high income years. When you start to receive maternity and paternal benefits, you withdraw money from your RRSP’s. This increases your income for that low income year.

To explain lets look at an example: It is 2004, Tom and Sue are 29 and 30 years old. Both have done well in school and in there careers. Tom makes $50,000 and Sue makes $70,000. They plan to start a family in three years time and they plan to have two kids. They have decided that Sue will take all 50 weeks off and Tom will continue to work.

For the next three years Sue will put $1000 a month into her RRSP’s. This will reduce her taxable income from $70,000 to $58,000 and she will get back about $4000 on her tax return each year. ($4000 X 3 years = $12,000)

Once the child arrives in 2007 Sue’s annual income will drop to about $21,500. To help manage the significant decline in her income, Sue will withdraw $3000 a month for the next twelve months out of her RRSP. This amount combined with her benefits will give her an annual income of $57,500. Because Sue will withdraw $36,000 from her RRSP, she will have to pay tax on that amount. This means she will have to pay $6800 in taxes when she files her 2007 tax return.

So, using the income splitting strategy, Sue will end up saving about $5200 in taxes and keep her income at the same level throughout her time off. ($12,000 tax returns – $6800 tax bill = $5200 tax savings)

If the child is born late in the year (Oct ‘09) Sue may choose to defer her benefits and RRSP withdrawals until the start of the next year (‘10), thereby deferring the tax payable on it until the following year (March ’11).

Income splitting is a strategy that is often overlooked but should be considered when planning a family. It provides the benefits of reduced taxes and consistent income.

Another advantage is that if you don’t need the money, you don’t have to take it out of your RRSP!

All numbers are approximations for example purposes. Every individuals situation will be different.