Written by Troy Peart
I grew up in a household in which my mother would often say to anyone that would listen: “What’s mine is mine and what’s his is mine.” For those of you that do not personally know my mother or are unfamiliar with this phrase, “his” is referring to my father whom she is still happily married to. In the context of this point of view, this month’s subject may seem like a strange thing to potentially recommend, however, spousal loans could be an excellent strategy for reducing taxes.
Canada has a graduated income tax system in which not every dollar of one’s income is treated equally. For example, an individual earning $80,000 of income pays 0% tax on their 10,000th dollar of income, 20.35% tax on their 30,000th dollar of income and 36.5% on their 80,000th dollar of income. Consequently, if an individual earning $80,000 of income received an additional $1,000 in interest income from their investments, they would have to pay $365 to taxes. Conversely, if their spouse earning $30,000 of income received this $1,000 of income instead, only $203.5 in taxes would have to be paid. According to my mother’s philosophy, this issue could be easily solved by the spouse with the higher income simply “giving” money to the spouse with the lower income to invest. Unfortunately, the Canada Revenue Agency (CRA) is one step ahead of my mother’s reasoning. If one spouse gave money to the other spouse to invest, CRA would simply tax the original spouse as if they still owned the investment.
One exception to this rule is if instead of giving the money to the other spouse to invest, a spousal loan is made at the prescribed interest rate. The prescribed interest rate is set by the federal government quarterly and was recently reduced to an all time low of 1% further enhancing potential benefits of this strategy.
To continue along with the aforementioned example, the spouse earning $80,000 could loan money to the spouse earning $30,000 at a 1% rate of interest. This 1% would be taxable as income to the spouse with the higher income but the spouse with the lower income would pay the lower income tax rate on all income from these investments. Additionally, the 1% interest that was paid could generally be deducted from these investment returns. To top things off, even though the prescribed rate of interest is set quarterly, a couple could continue with the 1% arrangement as long as the interest is paid prior to January 30th of the following year.
Spousal loans are an excellent strategy for income splitting which has the net affect of reducing a couple’s overall tax bill. As a result, CRA has specific rules and regulations governing how spousal loans can be implemented and applied in order to remain valid. Professional advice should be consulted to ensure that one maximizes the benefits of this strategy in conjunction with their overall financial planning.
Troy Peart BBA, CFP, CFA can be emailed at firstname.lastname@example.org.
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