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There's an opportunity to increase your family's net worth by lending money to a lower-income spouse for investing. But if you're going to do this, do it right. Let me explain.
The concept
By lending money to your lower-income spouse you can create investment income in your spouse's name that will be taxed at a lower rate than if you had earned the income.
Typically, you'd transfer cash to your spouse and take back a promissory note to establish the loan.
If you charge our government's prescribed interest rate on the loan your spouse will pay tax on any investment income earned in his or her name. If you fail to charge this interest, the attribution rules in our tax law will kick in and cause you – and not your spouse – to pay the tax on the investment income.
The interest must be paid to you by Jan. 30 each year for the prior year's interest charge. If your spouse fails to make this payment, the attribution rules will apply from that year forward. The good news is that, today, the prescribed rate is just 1 per cent. Even better, that rate will apply for the entire life of the loan, even if the quarterly prescribed rate rises in the future.
The savings
What's the financial benefit here? Suppose you lend your spouse $100,000. Suppose also that you're in a high tax bracket in Ontario with a marginal tax rate (MTR) of 46.4 per cent and your spouse has a MTR of 20.1 per cent. Let's also assume your spouse can earn 6 per cent on a balanced portfolio.
In the first year, your spouse will earn $6,000 of investment income ($100,000 at 6 per cent), will pay tax on that income, but will also be entitled to deduct the interest of $1,000 ($100,000 loan at the 1-per-cent prescribed rate) paid to you. You'll face tax on the $1,000.
At the end of, say, a 20-year period, the total added to your family's net worth after all tax savings would be just over $65,000.
For a $500,000 loan to your spouse, simply take this value and multiply it by five; multiply it by 10 for a $1-million loan. You get the idea.
The problem
Many who have set up spousal loans don't pay much attention to the asset allocation of the portfolio.
Take our example above. Suppose your spouse still earns 6 per cent, but it's all in the form of capital gains – most of which are unrealized capital gains each year, but a small portion are realized gains.
In this case, there's very little annual income to be taxed in your spouse's hands. After that same 20-year period, you'd basically break even as a family. There would be no benefit to the strategy.
Now take an example where, of the 6-per-cent return, 3 per cent is in the form of Canadian dividends while the balance is in unrealized capital gains. In this case, the net benefit to the family is about $50,000 over 20 years.
If the asset allocation were changed such that the 6-per-cent return is made up of 1-per-cent interest, 3-per-cent Canadian dividends, 1-per-cent realized capital gains, and 1-per-cent unrealized capital gains, you'll achieve a net benefit of $65,120 over 20 years (this is the balanced portfolio I first spoke about above).
The moral
You can save meaningful tax dollars and add to your family's net worth with a spousal loan. Consider setting up a loan today, while the prescribed rate is still just 1 per cent. The more income the portfolio generates each year, the greater the value of the strategy. So, if you're going to use this idea, consider moving the fixed-income portion of your non-registered money into your spouse's hands – not the portion of your portfolio allocated to long-term growth.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author and founder of WaterStreet Family Offices.
Tim Cestnick