Income splitting is a tax reduction strategy employed by couples or families to redistribute income among family members, reducing their overall tax liability and optimizing retirement planning.
In some cases, shifting income from a higher-income family member to a lower-income family member in a lower tax bracket can lower the family’s total tax burden.
This approach is particularly effective in jurisdictions like Arizona, where state and federal tax systems create opportunities to leverage income splitting for immediate tax savings and long-term financial security.
In this article, we explore income splitting, how it can be applied to your tax situation, and its role in retirement planning, with specific considerations for Arizona residents.
If you would like to find out if income splitting is right for you, please call ARQ Wealth at (480) 214-9572 to speak with a financial advisor.
What Is Income Splitting?
Income splitting involves transferring income from a higher-income family member to a lower-income family member. The goal is to reduce the total tax burden by taking advantage of progressive tax rates, where higher income is taxed at higher rates. In turn, this will allow families to lower their combined tax liability.
The Internal Revenue Service (IRS) and Arizona’s tax laws establish guidelines for splitting income, and compliance is crucial to avoid penalties.
How Income Splitting Applies to Taxes
Income splitting can significantly reduce federal taxes by leveraging differences in federal tax brackets.
However, Arizona has a flat 2.5% tax system, meaning everyone pays the same tax rate, no matter how much money they earn. This means that income splitting on the state level is not beneficial.
Here are some practical ways to apply the strategy for federal tax purposes:
Pension Income Splitting
Retirees can allocate up to 50% of eligible pension income (e.g., from defined benefit plans or certain annuities) to a spouse for tax purposes, provided both spouses agree and file a joint return.
If the receiving spouse has less income, this shift can reduce the couple’s combined tax rate.
It’s important to note that not all pensions qualify (e.g., some government pensions are excluded), and state tax benefits vary.
Spousal IRA Contributions
A higher-earning spouse can contribute to a traditional or Roth IRA for a non-working or lower-earning spouse, up to the 2025 limit of $7,000 (or $8,000 if the spouse is 50 or older).
Contributions to a traditional IRA may be deductible, reducing the higher earner’s taxable income.
Roth IRA contributions aren’t deductible, but qualified withdrawals are tax-free, providing future tax savings.
Income-Producing Investments
You can transfer funds or assets to a lower-earning spouse or family member (e.g., a child or parent) to generate investment income (dividends, interest, or capital gains) taxed at their lower rate.
For example, gifting cash to a spouse to invest in a taxable account shifts future income to their tax bracket. Gifts must comply with IRS gift tax rules (the 2025 annual exclusion is $18,000 per recipient).
For 2025, individuals with taxable income below $47,025 (single) or $94,050 (married filing jointly) pay 0% on long-term capital gains and qualified dividends, compared to the 15% or 20% rates applicable to higher earners.
For children, the “kiddie tax” may apply, taxing unearned income above $2,700 at the parent’s rate. In community property states like Arizona, investment income must be split equally on tax returns.
Small Business Income Splitting
If you own a small business, you could pay a reasonable salary to a lower-earning spouse, child, or family member for legitimate work performed. This shifts income to their lower tax bracket and provides a business expense deduction.
For example, paying a spouse $40,000 for administrative work deducts that amount from business income and taxes it at the spouse’s rate.
A child can earn up to $14,600 (standard deduction) tax-free.
Trust-Based Income Splitting
Set up a trust to distribute income to family members in lower tax brackets, such as children or grandchildren.
The trust can hold income-producing assets, and distributions are taxed at the beneficiary’s rate.
For example, a trust generating $20,000 in income for a child with no other income may be partially tax-free.
It’s important to note that the kiddie tax may apply to unearned income for minors.
Income Splitting for Retirement Planning
Income splitting is a powerful tool for retirement planning, as it helps couples maximize their after-tax income in retirement.
By strategically distributing income, couples can ensure they draw down retirement savings efficiently, preserve wealth, and maintain financial stability.
Here’s how the strategy can enhance retirement planning in Arizona:
Optimizing Retirement Account Withdrawals
Couples can coordinate withdrawals from retirement accounts, such as 401(k)s or IRAs, to keep both spouses in lower tax brackets.
For example, if one spouse has a large 401(k) balance, they might withdraw only enough to stay within a lower federal tax bracket, while the other spouse draws from a smaller account.
This approach minimizes taxes and extends the longevity of retirement savings.
Social Security Benefits
Social Security benefits can also be optimized through income splitting.
Couples can effectively manage their combined taxable income by timing when each spouse claims benefits.
In Arizona, Social Security benefits are not taxed at the state level; however, federal taxes may apply if the combined income exceeds certain thresholds.
A wealth advisor can help determine the best claiming strategy to reduce federal tax liability.
Tax-Free Income Streams
Arizona residents can use income splitting to create tax-free income streams in retirement.
For instance, contributing to a Roth IRA allows tax-free withdrawals in retirement.
Since Arizona follows federal rules for Roth IRAs, this strategy can provide tax-free income that doesn’t impact state tax calculations.
Legacy Planning
Income splitting can also support legacy planning by preserving wealth for heirs.
By reducing taxes during retirement, couples can maintain larger investment portfolios or retirement accounts to pass on to their heirs.
Arizona’s lack of an estate tax makes it easier to transfer wealth, but federal estate taxes may apply to larger estates.
A wealth advisor can integrate the strategy with estate planning to maximize inheritances.
Arizona-Specific Considerations
Because Arizona has a flat 2.5% tax system, income splitting on the state level is not beneficial, and it is also not beneficial for married couples who file jointly.
Arizona also does not tax Social Security benefits, making it an attractive state for retirees using income splitting. However, Arizona does tax pension income and withdrawals from traditional IRAs and 401(k)s, so careful planning is essential.
Another consideration is Arizona’s community property laws, which treat most income earned during marriage as jointly owned. This can complicate income splitting strategies, as income from community property may need to be reported equally on federal and state tax returns.
The wealth advisors at ARQ Wealth are familiar with Arizona’s laws and can navigate these complexities to ensure compliance and maximize savings.
Why Consult a Wealth Advisor for Income Splitting?
Income splitting is a nuanced strategy that requires careful planning to comply with IRS and Arizona tax rules. Mistakes in income splitting, such as improper documentation or exceeding pension splitting limits, can trigger audits or penalties.
Advisors help you avoid these risks.
In Arizona, where tax and estate laws differ from those of other states, a local wealth advisor is particularly valuable. They can tailor strategies to leverage Arizona’s tax advantages, such as the exclusion of Social Security from state taxes, while addressing community property rules.
The tax and retirement planning experts at ARQ Wealth can work with you to craft a tailored income splitting plan that aligns with your financial goals and complies with Arizona’s tax laws.
Take the first step toward smarter tax and retirement planning by scheduling a consultation with an ARQ wealth advisor today.
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