Here’s why you might.
We all look for ways to reduce the amount of tax we pay. Sometimes I come across situations where one spouse has accumulated a larger non-registered investment account than the other. This can happen over time when one spouse has a higher income than the other, or perhaps when one spouse receives an inheritance.
This often leads to higher taxes being paid by the household. In an effort to reduce taxes, income splitting strategies can help shift income from a high tax bracket family member to a low tax bracket family member.
This is not as simple as making a non-registered account ‘joint’ with a lower income spouse or minor child. CRA would consider this a gift to a non-arm’s-length person and attribution rules would apply, essentially attributing most if not all of the income back to the higher income individual and taxing it in their hands.
One income splitting strategy where attribution rules would not apply is to use a spousal loan.
A spousal loan works like this:
- The higher tax bracket spouse (lender) loans funds to the lower tax bracket spouse (borrower) at the prescribed rate.
- The prescribed rate is set quarterly and is based on the 90-day Treasury bill rate. Today that rate is at a historic low of only 1%!
- The borrower must pay interest on the loan annually by January 30 of the following year ($1,000 for a $100,000 loan).
- The investment income generated is taxed in the hands of the borrower, not the lender.
- The interest paid on the loan can be deducted by the borrower and is taxed in the hands of the lender.
- A written agreement should be put in place documenting the loan. This also locks in the rate of 1% for the life of the loan, regardless if the prescribed rate increases in the future.
To illustrate the potential benefits of this strategy, let’s look at a hypothetical couple Tom & Mary Connor.
Tom recently inherited $500,000 from his mother. Tom faces a marginal tax rate of 46.41% while his wife Mary’s marginal tax rate is 31.15%. Tom plans on investing the money and can earn 5%. For simplicity, let’s assume the 5% return is simple interest.
If Tom invests the funds himself, his after-tax return would be $13,397.
$500,000 x 5% x (1 – 46.41%) = $13,397.
Instead, Tom can lend Mary $500,000 at the prescribed rate of 1%, thereby shifting the growth on the money to Mary who is in a lower tax bracket while avoiding attribution rules.
Tom would include the $5,000 in interest on the loan as income, providing an after-tax return of $2,680.
Mary would include $20,000 in interest as income (5% return less 1% in interest costs), providing an after-tax return of $13,770
The total after-tax return for the household is $16,450.
The spousal loan strategy has provided an incremental family return of $3,053 after one year. As the portfolio grows and the resulting income from the portfolio increases, the incremental improvement in family return also increases.
This tax-planning strategy does however have potential non-tax consequences that should be considered:
- You may be more likely to be reassessed by CRA.
- Tax returns become a bit more complicated.
- If the marriage breaks down, the situation will become more complex and will be subject to family law provisions.
Your entire financial situation, goals & objectives should be considered before employing any strategy. If you find yourself in a similar situation to Tom, a spousal loan may work very well, especially considering the historically low prescribed rate of 1% that can be locked in today.
Written by Brad Mol, Senior Wealth Advisor, TriDelta Financial