A couple of years ago, I wrote about income splitting strategies to help reduce family taxes in the scenario that one spouse makes significantly more income than the other. Strategies such as:
- Contributing to the lower-income spouses TFSA (no attribution rules for TFSA contributions);
- Maintaining separate bank accounts where the higher income spouse pays for household expenses, while the lower-income spouse contributes to a taxable investment account;
- Contributing to a spousal RRSP;
- Spousal investment loans; and,
- Pension splitting (you can split RRIF when you turn 65).
You can read more detail on these income splitting strategies here. One strategy that has been coming up lately revolves around the strategy of spousal investment loans.
How a Spousal Investment Loan Works
A spousal investment loan strategy is where a higher-income spouse loans money to the lower-income spouse for the purposes of investing and staying onside with CRA. You would think that one spouse could simply give money to another spouse to invest in a taxable account. However, CRA does not allow this with its defined attribution rules.
Essentially, any gains and taxation from those investments would be attributed back to the higher income spouse if the funds are simply gifted from the higher income spouse to the other.
A spousal investment loan is essentially the same as a regular investment loan, except it is one spouse lending money to the other, instead of the bank doing the lending. Providing the loan is put towards a taxable investment account, the interest is tax-deductible by the lower-income spouse, and the investments will face lower taxation.
The higher income spouse would need to report the interest income when filing taxes. How much interest is expected? CRA publishes, on a quarterly basis, a prescribed interest rate which is the lowest that can be charged for a spousal loan. As of today (August 2019), the prescribed rate is 2%. The beauty of the loan is that once it’s issued, the interest rate stays fixed for the term of the loan.
If you have a handle on the other income splitting strategies listed above and still have excess cash to invest in a non-registered account, then a spousal investment loan can make a difference. How much? Let’s take a look at an example.
- A family with one spouse making $100,000/year in Ontario and the other a stay-at-home spouse earning $0/year. Say the higher income spouse has been saving her/his bonuses over the years and has accumulated $100,000 to loan to the lower-income spouse to start a taxable portfolio.
- If the higher income spouse invests the money in a taxable account, according to taxtips.ca, dividends are taxed at 25.38% and capital gains at 21.70%.
- On the other hand, if the lower-income spouse invests the money, the dividends are taxed at -6.86% (yes negative!) and capital gains at 10.03%.
- The lower-income spouse would need to pay interest on the loan ($2,000 but also tax-deductible), and the higher income spouse would need to pay tax on the interest income (~$868).
- Building a dividend growth portfolio yielding 4% (and assume no selling) would result in $4,000 in dividends for the year. The lower-income spouse would pay $0 in tax, while the higher income spouse would have needed to pay $1,015.20 in tax if invested in his/her own investment account. This results in an annual savings of $147.20 ($1,015.20-$868). Since it’s a dividend growth portfolio, the growing dividends will result in the savings growing by 14% to 20% per year (assuming dividend growth of 5% – 10% per year).
- The savings shown above do not include capital gains tax savings which would result from selling off the portfolio in the future to possibly fund retirement.
The savings really escalate as the income difference rises. Let’s take a look at another example with one spouse being a physician making $300k/year and a stay at home spouse. Using the same investment portfolio above:
- The lower-income spouse would need to pay interest on the loan ($2,000 but also tax-deductible), and the higher income spouse would need to pay tax on the interest income (~$1,070.60).
- Building a dividend growth portfolio yielding 4% (and assume no selling) would result in $4,000 in dividends for the year. The lower-income spouse would pay $0 in tax, while the higher income spouse would have needed to pay $1,573.60 (39.34% tax on dividends) in tax without using spousal investment loan. This results in an annual savings of $503 ($1,573.60-$1,070.60). Since it’s a dividend growth portfolio, the growing dividends will result in the savings growing by 14% to 20% per year (assuming dividend growth of 5% – 10% per year).
- Doubling the spousal loan to $200,000 will result in interest tax of $2,141.20, but a dividend tax savings of $3,151.20. This results in a net savings of $1,010/year (and increasing with dividend raises). Again, this does not include capital gains tax savings.
Not only does this result in savings today, but during retirement would result in more even income and reduced family taxation.
While other income splitting strategies should be implemented first prior to utilizing a spousal investment loan: like setting up separate accounts; contributing to the lower-income spouses TFSA; and, setting up a spousal RRSP; there are extra tax savings to be had using the spousal investment loan strategy.
As you can see from the examples above, the larger the income difference between the spouses, the greater the savings. In addition, the larger the loan, the bigger the savings.
There are some caveats, however. Savings are not as apparent when the investment funds are used for a lower dividend portfolio, like an index ETF portfolio. Building a lower dividend portfolio would result in lower savings now, but capital gains tax savings down the road.
You’ll need to work out the numbers to see if this strategy will work for you and your family. For us, we are just about finished setting up a spousal RRSP with a favorite discount broker, and the next step will be a spousal investment loan to continue building our dividend income streams.
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