What Is Income Spreading?
The term income spreading refers to a tax reduction strategy typically used by people with highly volatile incomes. This strategy involves particularly large sources of income and dividing the amount realized over a number of years to reduce the overall amount of taxes paid. Doing so ultimately reduces an individual's overall marginal tax rate. 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 bill.
Key Takeaways
- Income spreading is a tax reduction strategy typically used by people with highly volatile incomes.
- It involves dividing large amounts of income realized over a number of years to reduce the overall amount of taxes paid.
- Individuals can use income spreading to avoid getting bumped up into a higher tax bracket, which can result in a greater tax liability.
- This tactic comes in handy if you have volatile income due to capital gains and/or severance pay.
- Income spreading is common when buyers purchase capital assets through installment payments or when individuals in Canada use retirement plan funds to go back to school.
How Income Spreading Works
We all know the old saying. There are two things that are certain in life—death and taxes. Everyone wants to live longer and no one wants to pay more in taxes. While you may not be able to avoid taxes altogether, there are ways in which you can minimize your tax liability—especially if you fall into a higher income bracket.
Tax brackets divide individuals into different tiers based on the amount of taxable income they earn. Those with lower annual incomes fall into a lower bracket while those who earn more fall into higher brackets. This results in lower tax liability for people who earn less and a higher bill for those who earn more.
One way individuals can lower their tax liability is through income spreading. This is a strategy that moves some of the income you earn in one year over two years or more. This is especially useful if you earn any extra money in a single year that puts you into a higher bracket, such as capital gains and severance packages. Businesses can also take advantage of this tactic by deferring commissions and earned income to other years.
Income Spreading vs. Income Averaging
Although the basic principle is similar, don't get confused between income spreading and income averaging. They are actually two different strategies. While income spreading is available to anyone with large incomes, income averaging is only available to farmers and fishermen in the United States.
An eligible business can shift some of its income from the current year to the three prior years, which are known as base years, using income averaging. This tax averaging option gives those in the farming and fishing industries a way to help maintain some balance in their tax obligations and offset the volatility and typical fluctuations in income that are common for businesses in those industries.
Individuals who want to use income averaging as a strategy must use Schedule J from the Internal Revenue Service (IRS) to balance out the current tax bracket with those from previous years for a total of three years.
Income Spreading vs Income Splitting
Income splitting is another common tax reduction strategy. While income spreading allows an individual to spread out any excess income over a number of years, income splitting works in a different way. This strategy allows one member of a family who earns more to transfer a portion of their income to a lower-earning member.
For instance, one spouse may be able to transfer a portion of their annual income to the other to reduce their tax bill if the couple files annual tax returns jointly. Or a parent may transfer part of their earnings to a child to end up with a lower tax bill.
Make sure you consult a tax professional to ensure you use the tax strategy that's right for you.
Examples of Income Spreading
People who fall into high-income brackets can use income spreading to cut down their tax bills. This is a common strategy used by professional sports stars and entertainers. They often want to employ an income-spreading strategy to smooth out the volatility of their income streams.
You can use income spreading when you sell a capital asset and the terms of the sale dictate that the buyer will make installment payments out over more than one tax year. This type of 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.
In Canada, individuals can take advantage of income spreading using their non-retirement-related income by placing a portion of their earnings into a registered retirement saving plan (RRSP) and withdrawing the amount when they want to go back to school. 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.
