How income splitting can create tax savings

TLDR:

• Income splitting is a tax-planning strategy that can help lower your family’s overall tax bill
• Income splitting involves shifting income from a high-earning family member to a family member of a lower tax bracket, taking advantage of their lower tax rate
• A prescribed rate loan is an effective strategy that can result in significant tax savings for families
• It’s important to consult with qualified tax and legal advisors before getting started with income splitting strategies

This is an edited version of a Perspectives article originally published on RBC Wealth Management website.

Looking for ways to save on taxes? If you have a spouse or common-law partner who earns less income than you (or vice versa), or if you have children or other family members with little to no income, you may be able to lower your family’s overall tax bill through income splitting.

When done properly, certain income splitting strategies can help you keep more of your after-tax income. These strategies can be particularly effective when the government’s prescribed interest rate is low, as that makes shifting income within the family even more beneficial.

[Note: Any reference to a “spouse” in this article refers to both a common-law partner and a legally married spouse.]

What is income splitting?

Income splitting is a tax-planning strategy that can shift income from a high-earning family member to a family member in a lower tax bracket, taking advantage of their lower marginal tax rate(s).

But there’s a catch. When considering income splitting, certain “attribution rules” may prevent splitting income between family members in specific cases. The rules can be tricky and depend on several factors, so it’s a good idea to speak with a tax advisor before trying any income splitting strategy.

Attribution rules are tax rules that treat the income as still belonging to the higher earner, limiting the opportunity for income splitting.

What is a prescribed rate loan?

Normally, tax rules stop you from shifting income to family members in lower tax brackets. One exception is a prescribed rate loan.

This tax-planning strategy lets you lend money to your spouse or adult child at the official interest rate set by the Canada Revenue Agency (CRA). They then invest that money, and any investment earnings above the loan’s interest rate are taxed in their hands, often at a lower rate. You can also make the loan to a family trust so that multiple family members, including your spouse, minor and adult children, as well as grandchildren, nieces or nephews, can benefit.

When the strategy is carried out effectively, the savings can be significant. For example — keeping in mind that the tax-free amounts vary by province and territory — a family member who has no other income may be able to earn up to approximately $12,000 of interest income, $24,000 of capital gains or $50,000 of dividend income – tax-free every year.

The CRA updates and publishes the prescribed interest rates every quarter. Whatever the rate is when you set up the loan is locked in for the life of the loan, even if it changes later.

2 common prescribed rate loan strategies:

1. Spousal loan strategy

One method of income splitting is a spousal loan strategy. This strategy can make sense when one spouse earns more than the other.

In this strategy, the higher-income spouse lends money to the lower-income spouse at the prescribed interest rate set by the CRA. The lower-income spouse then invests the funds in their name, and any investment earnings above the loan’s interest rate are taxed at their lower rate.

Example: Tammy and Albert are married. Tammy earns a higher income than Albert and has a $350,000 non-registered investment portfolio. To reduce the family’s tax bill, Tammy lends Albert money at the CRA-prescribed interest rate using a demand loan agreement. Then, Albert invests the money in his name. The investment income he earns — which may include interest, dividends and capital gains — above the loan’s interest rate is taxed at his lower rate.

2. Family trust strategy

A family trust works in a similar way but can benefit more than one family member.

Typically, parents or grandparents set up a prescribed rate loan to a family trust for the benefit of their children, grandchildren, nieces or nephews. With this approach, you can lend money to a properly structured trust at the CRA-prescribed interest rate, and those loaned funds are then invested by the trust. Any investment income (less the annual interest payment) will be taxed in the hands of your family members who are named as beneficiaries of the trust. If the family member is a child or grandchild, for example, they may pay little or no tax.

With this approach, you retain access to the money loaned, and it can be an effective strategy to fund expenses that directly benefit the child. For example, the investment income allocated to your children or grandchildren can be used to pay for school tuition, camp fees or lessons. Normally, these expenses are paid by the parent with after-tax dollars, making this a more tax-effective way to fund them.

Example: Omar and Isabelle have a four-year-old son, Jonah. They’d like Jonah to attend private school and are already thinking ahead to potential post-secondary education costs. They lend $500,000 to a family trust for Jonah’s benefit. The trust invests the money, and all interest income, dividends and capital gains are taxed at Jonah’s lower tax rate. Any income of the trust over and above what’s needed to cover Jonah’s expenses can be paid to Jonah, so it’s taxed in his hands.

Keep in mind, family trusts involve additional administration, record-keeping and costs, so work with tax and legal advisors to make sure it is set up correctly and continues to operate properly over time.

Key factors to keep in mind

• Prescribed rate loans work best as part of a long-term financial plan. Results may vary depending on investment performance and tax rates over time.
• If you sell investments to fund the loan, you will trigger capital gains, which are taxable.
• This strategy may not be as tax-effective for your family if you plan to invest in a very tax-efficient portfolio.
• The borrower must be able to pay the interest to you each year, as set out in the loan agreement, by the January 30 deadline to avoid the attribution rules.
• If the annual interest payment is not paid to you by January 30 of the following year, the attribution rules will apply. Even if the deadline is missed by one day, the attribution rules will be triggered. Once that happens, attribution will apply to that year and all following years.
• Interest payments from the borrower should be made in a way that demonstrates they have used their own funds.
• If you already have an established prescribed rate loan and the CRA-prescribed rate falls, you may be able to modify your loan to benefit from the lower prescribed interest rate. Keep in mind this needs to be executed carefully with the help of your advisor; if not done correctly, there may be negative tax consequences.
• Over time, it’s important to consult with a qualified legal advisor to ensure the loan agreement stays valid in your jurisdiction.

Watch this video to find out more about prescribed rate loan planning.