Hello everyone and welcome to the Retiring Canada Podcast. In today’s episode, we're going to discuss the spousal loan strategy.
Specifically, we are going to discuss:
- Who may be a good candidate for this strategy
- The core mechanics of a spousal loan
- How to set one up
- An example of the potential tax savings
- Key considerations and drawbacks
- Lastly, a few action items for you to consider
I know the episode title may come off a bit crass, but the fact of the matter is that some tax planning strategies can only be implemented once your investable assets have reached a certain level.
One such strategy I will be speaking about today is called the Spousal Loan Strategy. In essence, this is an income-splitting strategy to minimize household tax on investment income. But before I discuss the details, let's start off by painting a picture of the household who should consider implementing this strategy.
First off, you are in a spousal or common-law relationship.
Next, your RRSP, Spousal RRSP, workplace pensions, and Tax-Free Savings Accounts have all been maxed out.
Next, you have little to no debt.
Next, one spouse has a significantly larger income than the other spouse.
Lastly, the high-income earning spouse has accumulated a large sum of non-registered investments over time, or perhaps from a business sale or some other sudden cash windfall. Usually, this amount should be in excess of $500,000 or more.
If you check these boxes, then the spousal loan strategy may make sense.
Ok, so now that we know who this can make sense for, let's get into a bit of the detail about what it is, how it can be implemented, the benefits, an example, and some considerations and potential drawbacks to wrap it all up.
The purpose of a spousal loan strategy is to shift future investment income earned in a non-registered investment from the higher income-earning spouse to the lower income-earning spouse.
If you need to brush up on non-registered accounts and how they are taxed, I suggest you have a quick listen to my previous episode and then jump back in to continue.
So how do you set this up?
To start, the higher income-earning spouse will loan non-registered investments to the lower income-earning spouse using a loan agreement and promissory note. This agreement states the loan principal, the parties involved, the current CRA prescribed interest rate, and when the interest is payable. This signed document is evidence that needs to be provided to CRA.
Now I tossed in one term there you may need some clarity on – the prescribed rate.
The Canada Revenue Agency determines the prescribed interest rate for loans to family members. Every three months, CRA updates this number. This rate does fluctuate and should be continuously monitored throughout the duration of the spousal loan strategy to ensure the lowest rate is being utilized... more on that a bit later.
Once you have this loan agreement in place, the funds must be transferred to the lower income-earning spouse to then invest.
I would strongly advise opening a new, separate non-registered account to hold these funds, so it makes it easier to track the investment income generated by the borrowing spouse.
Next is to now have the lower income spouse invest these assets to start generating investment income. Because the effectiveness of this strategy hinges on the return of the investment, it's crucial that the portfolio be constructed properly.
So, what does that mean in English? Well, in today's environment, with the prescribed interest rate being 6% and GICs yielding between 4 and 5%, it will be imperative to build a well-diversified portfolio that includes equities.
Assuming we have a suitable portfolio now in place, the lower income-earning spouse will now make annual interest payments set out by the loan agreement no later than January 30th of the following year.
So as a quick recap: If you and your spouse are suitable candidates for this strategy, you will need to draft a promissory note and loan agreement, transfer funds to a new non-registered account, invest properly, and lastly, ensure interest payments are made annually and filed with CRA.
Let’s go through an example to make sense of this.
For a visual of this example, please open the show notes and click on – Spousal Loan Example. To keep things simple here, any rates of return discussed will be considered fully taxable as income.
So, let's assume the higher income spouse sold shares in a private business and is left with $1,000,000 after tax.
Let’s also assume the high-income earning spouse is in the 50% marginal tax bracket and invests these proceeds into a non-registered account that earns 8% on average.
This would mean our high-income earner receives $80,000 in taxable income from the investment taxable at their marginal tax rate of 50%, leaving them with $40,000 after tax.
Now let's assume the high-income earner loans this $1,000,000 to the lower income-earning spouse to invest.
The lower income spouse earns 8%, so the same $80,000 of taxable income. They are then required to pay the interest on the loan of $60,000 to the high-income earning spouse, which is now taxable in their hands.
The lower income-earning spouse has a net taxable income of $20,000 taxed at 25%, while the high-income earning spouse pays tax on $60,000 at their marginal tax rate of 50%.
The net result is a household after-tax income of $45,000.
So when we put all this together and compare the high-income earner just investing the funds themselves vs. a spousal loan, the net tax savings of utilizing the spousal loan for this hypothetical couple is $5,000.
If we take these savings out over 10+ years and start to compound the lower income-earning spouse's investment account, we start to see some real tangible long-term tax savings.
Another key benefit, other than saving tax, especially for retirement investors, is the potential for this income-splitting opportunity to reduce or eliminate an OAS clawback. You can learn more about OAS clawbacks in episode 15 of the podcast.
Now as with anything, there are a number of key considerations to this strategy that you should be aware of before implementing.
First off, the elephant in the room: a high prescribed interest rate. With the current rate in Q2 2024 being 6%, your underlying investment needs to be generating a return higher than this rate. So if you are a conservative investor, this strategy off the top will just not make sense. You will need to have the risk tolerance and timeline to justify holding a large portion of this portfolio in equities in order to earn a higher expected return over the long run, which of course, is not guaranteed.
Furthermore, you need to consider how a properly structured portfolio in the high-income earning spouse's hands may negate the need for a spousal loan. A portfolio that generates a return of capital or deferred capital gains may be better off staying put in the higher income earner's hands.
In the case where an investment portfolio already exists that holds stocks, bonds, ETFs, or whatever else is in there, you will need to consider the tax implications of the change of ownership along with ensuring the superficial loss is accounted for.
Next, there is the need to continuously monitor this strategy. Specifically, the payment of the loan interest and the re-writing of the loan to a lower prescribed rate if or when rates decrease.
Regarding the loan interest, if CRA doesn't receive this loan payment by January 30, then all of the investment income generated that year, and all subsequent years, will be attributed back to the high-income earning spouse and will completely nullify the strategy.
You will also want to be sure you are monitoring the government's quarterly prescribed interest rate changes and consider making changes to your existing spousal loan if or when rates decrease. There may be tax considerations for the lower income-earning spouse, however, issuing a new, lower prescribed rate loan is likely to be more beneficial over the long run.
Next is tax rates. If there is an expectation that tax rates will change between either spouse, you will want to ensure you consider how these changes may impact the viability of the strategy.
Lastly, although you can draft a promissory note and loan agreement yourself, you may want to consider having these documents drafted by a lawyer, which does have an added cost.
Now after going through that list of considerations, admittedly there are a lot of hoops to jump through to determine if this strategy even makes sense and some work on the back end to ensure it continues to run smoothly.
At the very least, if you fit the description of the couple I outlined at the beginning of the episode, it will make sense to go through the exercise of evaluating the strategy.
If you find yourself on the fence and not too sure where to start, I encourage you to reach out to our team for help.
Alright, so that does it for today's episode. Only one action item for today:
Have a look at your overall balance sheet. If you fit the description of the hypothetical couple I described, you should take a serious look at this strategy. With the potential changes to the capital gains inclusion rate, it only heightens the importance of reviewing this tax strategy, along with a multitude of others, to help keep your household taxes as low as possible.
Ok, that will do it for today’s episode.
For the links and resources discussed, please check the link in the show notes or visit retiringcanada.ca.
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All comments are of a general nature and should not be relied upon as individual advice. The views and opinions expressed in this commentary may not necessarily reflect those of Harbourfront Wealth Management. While every attempt is made to ensure accuracy, facts and figures are not guaranteed, the content is not intended to be a substitute for professional investing or tax advice. Please seek advice from your accountant regarding anything raised in the content of the podcast regarding your Individual tax situation. Always seek the advice of your financial advisor or other qualified financial service provider with any questions you may have regarding your investment planning.