The Problem: Who Pays Tax on Investment Income?
In almost every family there is one spouse who earns a higher income than the other. In some families the gap between incomes is material. For the purposes of this article, let’s call the higher earning spouse “Richie” and the lower earning spouse “Penny”. Unfortunately, our Canadian tax rules prevent couples from splitting income between Richie and Penny. There are some great ways that Richie can get money into Penny’s name such as TFSAs and Spousal RRSPs. But after that, if Richie wanted to give Penny some money to invest, the resulting investment income and gains may be attributed back to Richie.
How a Spousal Loan Works
A spousal loan structure allows Richie to give Penny money to invest and the growth on those investments will be attributed to Penny, not Richie. Here is how it works:
Richie lends money to Penny at the CRA’s prescribed interest rate. (Currently 3%)
Penny invests the funds and reports the resulting investment income and capital gains on her tax return.
Penny must pay Richie, the lender, interest by January 30 of the following year. This interest is tax deductible to Penny.
Richie reports the interest received from Penny as income.
When Can the Strategy Make Sense?
Even if your family has a Richie and Penny this strategy may not make sense.
Size of income gap: If the difference in Richie and Penny’s taxable income is too small, shifting assets and investment growth to Penny might have a nominal impact.
Availability of funds to loan: Unless Richie is sitting on cash, he may need to sell assets and trigger tax in order raise the cash to give to Penny. This needs to be considered in the calculation of the overall benefit of the strategy.
Penny’s risk appetite and aptitude: Penny would need to be willing and suited to take on the investment risk and interest payment obligations.
Expected investment return: If the investment gains do not out-pace the lending rate then they would end up paying more overall tax.
Timeline: The investment portfolio needs to generate enough taxable income or gains for the potential tax savings to be worthwhile. If the couple needs to withdraw the funds in the short term they may need to windup the loan before it has much benefit.
Other income splitting opportunities: If the couple is close to age 65, will be in receipt of a defined benefit pension, or have a corporation, there may be other income splitting options available to help achieve tax savings without the complexity of a spousal loan.
A Simple Example
Here is an example on how this could work for Richie and Penny, both 50 years old.
Richie has an annual income of around $500k.
Penny works part time with an annual income around $20k.
Richie and Penny have maxed out their TFSAs, made strategic contributions to Penny’s spousal RRSP, and have funds set aside for short term financial needs. They have no non-registered investments.
Richie is sitting on $1M in cash which he received from selling recently vested shares from his company.
Richie loans the money to Penny and Penny invests it in a stock/bond portfolio.
The portfolio grows to $2M in 15 years.
Richie decides (with advice from Richie’s accountant and financial planner) to call back the loan, transferring $1M back to Richie. Now their non-registered investment portfolios are approximately equal and the tax on the growth and investment gains will be approximately equal going into retirement.
Is It Worth It for you?
A spousal loan can be a powerful tool to save on tax, but it doesn’t make sense in every situation. If you believe this strategy is worth considering, be sure to discuss with your financial planner and tax professional before implementing.
