Kevin Greenard: Spousal loans help split retirement income

Kevin Greenard

When we first meet with younger couples, we begin educating them about the benefits of equalizing incomes once they reach retirement. The higher income spouse should pay all the household bills, fund the TFSA accounts, make spousal RRSP contributions, etc. The lower income spouse should save all earned income. Young couples have the benefit of time to help reach the retirement goal of equalizing income.

Hopefully, throughout a couples’ working years, little steps were completed to help equalize income levels. Despite time and dedicated efforts to split income, it is still common that when a couple enters retirement, that each of their total incomes (line 15000 on the tax return) will be different. In many situations, splitting eligible pension income can equalize income levels. The lower income spouse can increase total income by electing an income inclusion through the split-pension amount (line 11600). The higher income spouse can have a corresponding deduction for the elected split-pension amount (line 21000) to better equalize net income (line 23600).

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In other situations, we have clients that have a significant difference in net income, primarily because the form of income they have is not eligible to be split with their spouse. In these situations, we will have a meeting to discuss all available strategies. One strategy outlined below is referred to as a spousal loan.

Spousal loans

The purpose of all income-splitting strategies is to transfer income from the higher income spouse to the lower-income spouse. A spousal loan is a perfectly acceptable strategy for couples to income split. For this strategy to be effective, couples need to be in different marginal tax brackets. The greater the difference in income levels, the more advantageous the strategy is from a tax savings standpoint.

Documentation and paper trail

It is important to document the terms of the loan, generally through a promissory note. Although this is not a requirement under the Income Tax Act, we feel it is prudent and provides appropriate evidence of the terms of the loan. We assist all our clients that have a spousal loan agreement in drafting the promissory note (the “note”). The higher income spouse signs the note as the lender. The lower income spouse signs the note as the borrower. I will witness the promissory notes. A properly executed note document will provide clarity for specific terms. One of these terms relates to the interest rate and the payment dates.

Prescribed interest rate

When we draft these notes, we will always select the lowest prescribed rate allowed by Canada Revenue Agency (CRA). CRA allows loans to be issued at the posted prescribed interest rate. Every three months, CRA sets the prescribed interest rate for loans. It is posted quarterly and is calculated based on the average yield of 90-day treasury-bills sold during the first month of the previous quarter. Currently, the rate is at a historic low of only one per cent. Once a spousal loan agreement is documented, the rate is guaranteed to stay at that level forever, even if the prescribed rate increases in the future. As the rate is currently at only one per cent, we are not expecting the rate to go any lower. This is the perfect time to act if the spousal loan strategy is suitable for your situation.

Demand note

In all situations, the notes we help clients set up are interest only demand notes. The lender can request the repayment of the loan upon demand (written notice); however, this is typically not done. The longer a spousal loan is put in place, the more effective it becomes.

Interest-only payments

All the spousal loan agreements we help draft for clients are structured with interest only payments. The specific CRA requirement, to ensure the funds are considered loaned (instead of gifted), is that the borrower (lower income spouse) must pay the interest payment by January 30 of the following year. If the lower income spouse does not pay the interest payment, then the total income of that spouse will be attributed back to the lender (higher income spouse). Annually, we ensure that our clients make the appropriate interest payments (see Multiple Joint With Right of Survivorship Accounts below).

Purpose of Joint With Right of Survivorship (JTWROS) accounts

Couples typically set up non-registered accounts that are Joint With Right of Survivorship (JTWROS). JTWROS accounts are typically opened for two different reasons: income splitting and estate planning. In the situation where a couple is contributing approximately equal amounts into the JTWROS then the income on the account is typically split 50 / 50. When one spouse is working and earning a significant income, and the other spouse is not working, then deposits to a JTWROS are typically done for estate planning purposes as the income is reported 100 per cent on the higher income spouse’s tax return. The higher income spouse is named as the primary account holder on a this JTWROS. For illustration purposes below, we will refer to this account as JTWROS 1 and the primary / higher income spouse reports 100 per cent of the income.

Multiple Joint With Right of Survivorship accounts

When we set up a spousal loan note, we will simultaneously open a second JTWROS account with the lower income spouse (the borrower) being the primary on the account. We still typically put the account in joint names for estate planning purposes. We will refer to this account as JTWROS 2 and the primary / lower income spouse reports 100 per cent of the income. We will have a letter of direction, that both the borrower and lender sign, that transfers the agreed loan amount from JTWROS 1 to JTWROS 2 on the agreed upon date. Annually, we have the interest payments being made from the JTWROS 2 account to the JTWROS 1 account.

Illustration One – One income household

Over the years, the higher income spouse has made all the taxable income. Over a series of years, the accumulated savings have been put into an investment account. From a tax standpoint, 100 per cent of this income needs to also be reported on the higher income spouse’s return. Unfortunately, you cannot simply gift funds to your spouse, who has no other income, to buy investments. Some may feel that the higher income spouse could put $300,000 in a non-registered investment account in the lower income spouse’s name to earn at least the basic personal amount tax free of $13,229 (2020). Let’s assume the account earns $12,000. The thought might be that the spouse has no employment income and transferring income would be below the basic exemption and not subject to any tax at all. The Income Tax Act has rules that prevent these types of transactions from taking place. These are referred to as the “attribution rules”. In the above case, the $12,000 of investment income would be attributed back to the higher income spouse who earned the income.

The way around the attribution rules is to lend funds to your spouse at the prescribed rate, currently at one per cent. Mrs. Walker has annual earnings from her medical practice of over $330,000 and over time has accumulated $1.25 million in non-registered savings. The amount is currently in an account similar to JTWROS 1 above where Mrs. Walker is reporting 100 per cent of the income. Her portfolio has been invested and has earned an average rate of return of seven per cent. Every year she has been reporting 100 per cent of the T5 investment income (interest, dividends, and capital gains) on top of her employment earnings. Typically, this is excess of $70,000 annually. As Mrs. Walker’s marginal tax bracket is already at 53.5 per cent from her medical practice, she is paying a significant amount of tax on the investment income generated. Mr. Walker has been busy raising three children and has no income at all.

A strategy we recommended to the Walkers is a spousal loan. Mrs. Walker could loan Mr. Walker $1.25 million at the prescribed rate of one per cent. We would open JTWROS 2 where Mr. Walker is primary and would report 100 per cent of the income. We would assist them in drafting the promissory note and documenting the paper trail to formally transfer the funds from JTWROS 1 to JTWROS 2. We would also assist the Walkers in ensuring that the annual spousal loan payment is made. Annually, Mr. Walker would be obligated to pay Mrs. Walker $12,500, which would be an interest deduction on his tax return. Mrs. Walker would have to include the interest payment of $12,500 on her tax return. This is significantly lower than the approximately $70,000 of investment income noted above. The best part is that the investment income earned by Mr. Walker in JTWROS 2 will be taxed at significantly lower tax rates.

Illustration Two – Large inheritance

Most of the spousal loan strategies we have implemented are when a large inheritance is received. We have had situations where a parent or sibling has left one of our clients a sizeable inheritance. To illustrate, we will use Mrs. Taylor. She had an older brother that had not married and had no children. When the brother passed away, Mrs. Taylor received $3.2 million from his estate.

Prior to this inheritance, Mrs. and Mr. Taylor had approximately the same level of income. All the investments they currently had were in Registered Retirement Income Funds (RRIF). During our meeting, we noted that Mrs. Taylor would have to report 100 per cent of all the investment income (i.e. interest, dividends, and capital gains) generated from investing the inheritance. We recommended some strategies to assist them to minimize tax during their retirement by splitting this income in a way that is acceptable for CRA. One of the most important discussion points in the meeting was explaining how simple it was to set up a spousal loan and how we take care of all the administrative components.

The steps we took with Mrs. and Mr. Taylor was to open up a Tax Free Savings Account (TFSA) for each of them. We also opened up JTWROS 1 with Mrs. Taylor as primary and JTWROS 2 with Mr. Taylor as primary. We created a promissory note for Mr. and Mrs. Taylor. Mrs. Taylor was agreeing to lend Mr. Taylor the principal sum of $1.5 million which was due on demand. The note would bear interest at one percent and have annual payments of $15,000. The effective date for the transfer was set for December 30 for the spousal loan.

The $3.2 million first was deposited to JTWROS 1. We transferred $69,500 into each of their respective TFSA accounts immediately. There is no attribution for a spouse to fund the other spouse’s TFSA account. On December 30 of the first year, we had Mrs. and Mr. Taylor sign a letter of direction to enable us to journal the $1.5 million form JTWROS 1 to JTWROS 2.

We assist the Taylors in ensuring that the annual spousal loan payment is made. Annually, Mr. Taylor is be obligated to pay Mrs. Taylor $15,000 which is an interest deduction on his tax return. Mrs. Taylor must include the interest payment of $15,000 on her tax return. This is significantly lower than the investment income the loaned amount would have otherwise earned.

Illustration Three – Selling a dental practice

In situations where a privately held company is sold, the shareholder often receives a significant lump sum of capital. Dr. Young was in this situation when he sold his dental practice with a completion date of June 20. He will be receiving $2 million dollars in personal funds. Dr. Young immediately wanted to talk about investing these funds to generate investment income throughout retirement. In talking with Dr. Young, I recommended that we first structure the investments in a way that reduces taxes and increases his after-tax cash flows. I asked that Dr. Young and Mrs. Young both come in for a meeting to discuss the spousal loan strategy. Dr. Young primarily had his investments within a holding company that had been built up significantly over the years. We had spoken with the Young’s accountant and the plan was to declare annual dividends for Dr. Young from the holding company of $130,000. Knowing that Dr. Young was already going to have some significant cash flow from these dividends, we recommended that the proceeds from selling the practice be set up as a spousal loan in Mrs. Young’s name.

We created a promissory note for Dr. and Mrs. Young. In this note, Dr. Young agreed to lend Mrs. Young the principal sum of $2 million, which was due on demand. The note would bear interest at one percent and have annual payments of $20,000. The effective date for the transfer was set up for June 30 for the spousal loan. We explained that for the first year the interest payment will be prorated for a half year and be only $10,000.

In this situation, we only opened one JTWROS with Mrs. Young being the primary on the account. Dr. Young wrote a cheque to deposit the funds into the JTWROS on June 30. This strategy will enable the Youngs to significantly reduce their annual tax bill to CRA.

The spousal loan strategy has saved our clients a significant amount of tax dollars over the years. Each of the illustrations above are similar to households we have helped, and all are considerably further ahead, after taxes, each year. As every year goes by, the benefit of this strategy is magnified even further.

Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management, with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at Call 250-389-2138.

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