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Income Splitting Strategies That Can Bring You Found Money

January 8, 2021 | Paul Chapman

As part of my “you don’t know what you don’t know series”, I try to shed some light on relatively straight forward concepts that you may not have otherwise been aware of, and that may save you significant money over time. Of course, these are high level concepts that I try to keep simple, so consult a qualified tax advisor when digging into these concepts and strategies to see if they’re a fit for you and your situation. I can help coordinate on this front, so feel free to reach out and I can help navigate.

Many families are in a similar situation – each partner may or may not bring in income, and the disparity between their income levels is often significant. The authorities have made it difficult to split the income between them – that is, have the higher earner ‘allocate’ some of their earnings to their lower-income common-law partner or spouse in order to have some of that income taxed at their lower marginal rate. But there are still means available to do this.

Apart from starting a small business to have your partner employed by you as the higher income earner, one simple strategy to employ is the spousal loan strategy. This strategy will lower the overall family tax bill by entering into a ‘prescribed rate loan’ arrangement. In short, you ‘loan’ money to your spouse, and he or she can invest that money and get taxed on the income generated by the portfolio at their low tax rate. An even better version of this structure is one where you can loan money to a family trust, and the income generated by the portfolio can pay for your kids expenses (e.g. private school fees, camp expenses, childcare expenses, sports fees, vacation costs) at their tax rate (which is close to nil)! The basic mechanics are really quite simple.

If you have non-registered savings or investments that are either sitting in cash, or generate largely income or yield (rather than a bunch of deferred capital gains or return of capital), or you just came into a bunch of money via an inheritance, windfall, etc, any investment income will be taxed at your current high marginal rate. The idea is to convert this to cash, and ‘loan’ this amount to your partner. The annual income generated by the portfolio should outweigh the interest on the loan. This interest rate is mandated by the CRA, and is currently only 1% given the interest rate environment we’re currently living in, so this should be fairly achievable. That rate is locked in for the life of the loan, and you can lock in a lower rate if the CRA’s prescribed rate drops, so there’s some added upside optionality on that front.

The longer this loan remains in place, the more effective it is. Let’s look at a simple example:

Let’s say Rebecca is an accomplished professional making $300k/year. She has built a $2mm non-registered portfolio that she feels isn’t as efficient as it could be. She’s paying high taxes on her portfolio’s growth given her marginal tax rate, so there’s a way to shift her investment income to her lower income spouse Bob who has no current income. Assuming she has a balanced portfolio achieving ~5.3% annual returns (mix of capital gains, dividends and interest), with a time frame of 25 years (age 40-65).

If you run the math here, and assume that she sells her holdings after the 25 years and pays the tax, she would have ~$4mm in hand from her original investment of $2mm today. Not too shabby. But, they’re leaving a significant amount of money on the table. Had she set up a prescribed rate loan to Bob at 1%, and invested the annual interest payments he made to her along the way, then after the 25 year period the net family balance (after selling and paying the taxes) would over $4.7mm! That’s almost $500k more in wealth created from simply utilizing this strategy. On top of this, they also now have individual portfolios moving forward that will give them the advantage of splitting the investment income from there on out.
 

A few things to keep in mind when employing this strategy (this is not an exhaustive list, please consult a professional for further info) – if you liquidate your portfolio to convert it to cash, watch the tax implications of that. Also, if your partner is going to invest in the same portfolio, watch out for the superficial loss rules, meaning that he or she may need to wait for 30 days to repurchase the same securities, or simply by similar securities if you’d like to deploy within that time frame. Finally, ensure you document the loan details properly, avoid the use of joint accounts here, and don’t be late in paying the interest on the loan, or else the attribution rules apply for all years this strategy is in place for. And you don’t want that as it would render this strategy useless in that case. The annual interest payment date is January 30th of the following year at the absolute latest.

So if you have significant non-registered savings or investments, this is a strategy that you should seriously consider. It doesn’t take a $2mm non-registered portfolio or cash slug as the illustration above is showing, it also makes sense for a lot lesser amounts – even a few hundred grand can yield worthwhile results of thousands of extra dollars in your pocket annually. And note that this strategy can be employed with adult children as well.

For more info on this or related strategies, feel free to reach out, I can shed further light on this subject, and/or send some brief RBC articles diving deeper into the subject.