Show Transcript
As interest rates rise, the opportunity to achieve tax savings via a family loan strategy is narrowing. Would a prescribed rate loan strategy still be worthwhile as the prescribed rate rises to 3% on October 1st? Georgia Swan, Tax and Estate Planner, TD Wealth weighs in.
Originally published on September 26, 2022
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- Interest rates have been rising, and so has something called the prescribed rate. And that could be a significant win for people who use a prescribed rate loan strategy to split investment income with a spouse. Here to explain how all that works, Georgia Swan, tax and estate planner with TD Wealth. So nice to have you here.
- It is so good to be here in person finally.
- It's better, huh? It was better in person.
- Let's talk a bit about the basics. What is a prescribed rate loan, and how does it work for income splitting?
- OK. So a prescribed rate loan basically is a loan between spouses. The purpose of it, as you said, is to split income. And the reason that you want that is because there's something in the Income Tax Act called the attribution rules, which basically means if I earn $100,000 and I deposit it into an investment account, even if it's joint with my husband, if that $100,000 earns 5%, that $5,000 income accrues entirely to me because I earned the income.
So we look for ways, legitimate ways and allowed ways, to basically split that income so we're paying on that investment income at lower rates. And the way you do that is the Canada Revenue Agency basically releases the prescribed rate, which is based on the three-month average of short-term Canada T-bills. And that rate, you can consider it as the lowest or pretty much the lowest rate that you can lend money and still have it be a valid loan.
So the way this income splitting works is if I then lend that $100,000 to my husband and he invests it, as long as he pays me interest back at the prescribed rate, he can declare the rest of that income at his marginal tax-- at his tax rate. And hopefully, his is lower than mine so we end up being able to split the income.
- OK. So I'm going to say this back to you. So two spouses. One has a high tax rate. One has a low one. The high-tax-rate person lends money to the person. The other person pays them interest, but then they get the income or dividends, whatever, the investments under theirs. And it's more tax-efficient that way, right?
- Exactly. Exactly.
- OK. Tick. I got an A on that one.
- You did.
- Let's talk about that example you use, which is great. Maybe you can talk a bit about the change in rate that has happened, what people need to think about.
- Right. So in Q1 and 2 of this year, the rate was at 1%. And then in Q3, it went to 2%. And now in Q4, it's going to 3%. And so that's significant because in the example that I gave of the $100,000 to my spouse, let's say I was at a 50% tax rate, my spouse was at 25%. If I invested that money and got a 5% return, so $5,000 of income, and I paid it at 50%, I would end up basically being left with $2,500.
If I lent it to my spouse-- and let's say he's at a 25% rate-- on that $5,000, he pays $1,000 to me. And let's say the interest rate at the time-- I did it early in the year. It was 1%. So let's say he pays the $1,000 to me. I declare it on my income tax return. I'm left with $500 because I'm at the 50% rate, but my spouse basically can declare the remaining $4,000 at his 25% rate. He's left with $3,000. And combined, we now have $3,500, whereas before where I was doing it alone, we had $2,500.
So in that example, what's important? That spread between his tax rate and mine. And then there's a number of other considerations that you also have to think about.
- So at 1%, it was a bit of-- everyone should do it. It makes a lot of sense. The higher the interest rate goes, you really do need to see that spread between the spouses to make it all work. OK. So the spread between the different tax rates between the two spouses is one thing. The next thing, you say, is consider future income of both spouses.
- Exactly, because these types of tax planning measures make sense when the spread between the tax rates between the spouses is significant. But as we're getting closer to retirement, perhaps, you have to reconsider whether this makes sense. Because a lot of times in retirement, we may have other options available, such as pension splitting, that bring our tax rates closer together.
You also have to consider, where is this money coming from? So for example, if it was from a long-term investment that I had and I had to liquidate it in order to make the loan, then I'm triggering, perhaps, capital gains that I then have to pay tax on before I even do this. So then you have to factor in, how much tax savings do we need to have before we get back to zero and then actually start saving because we've triggered this gain?
There's also actually fees involved because this has to be a proper loan. So there has to be a loan agreement. There has to be terms in the loan. You have to make sure that the money is paid back, so there may be legal fees. There may be accounting fees. So all of these things have to be factored in as to whether it makes sense at 3%. And as well, that investment return needs to be pretty high too.
- Yeah, which is funny because-- I mean, not funny. The markets have been tricky over the past little while. So lending money to a spouse and not having an investment make money to begin with, that's a lose-lose proposition, I think, on that side too.
- Exactly.
- Are the legal fees and the accounting fees, are they significant to set something like this up? I mean, can you just write a piece paper? I'm going to do this to you, and just--
- Well, no. I'm not going to say that they are overly significant. Having said that, it's not really something that is meant to be done around the kitchen table. This is sophisticated tax planning. And in discussing the different variables we just talked about, you need somebody to make sure that they've looked into that for you. So it is important to make sure you get the right professionals in place to do it. Yes, it is a fairly simple loan agreement, but it depends on the build-up to that.
- Yeah. That's why we have Georgia here. That's why I am not doing this for you. Someone like Georgia can. Let me ask you-- I know you mentioned this is an interesting thing to keep in mind, too, for funding things like school expenses, grandkids expenses, private schools, those types of things, extracurriculars. And that involves a family trust. And maybe tell me just how that could work.
- Mm-hmm. So a lot of times, we have these family trusts set up, but maybe they're not making a significant amount of income within the trust. It depends on what the value of assets is in it. And especially when you get to the stage of a lot of family trusts when the younger beneficiaries-- and I call it the sweet spot when they're 18 to 24 and maybe in higher education, but they're not really earning their own income-- you kind of wish that the trust was making more money than it was.
So you can use a prescribed rate loan by actually lending money to the trust at a prescribed rate, same idea as before. And that way, you get more assets into the trust that are then generating income that you can flow out to those beneficiaries. The alternative-- you can't just sort of dump money into a trust. That has all sorts of tax problems. But if you do it through a prescribed rate loan, you can actually have the same result and get that trust maybe earning more income during that time, that sweet-spot time, as I say, when you really need it.
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- Interest rates have been rising, and so has something called the prescribed rate. And that could be a significant win for people who use a prescribed rate loan strategy to split investment income with a spouse. Here to explain how all that works, Georgia Swan, tax and estate planner with TD Wealth. So nice to have you here.
- It is so good to be here in person finally.
- It's better, huh? It was better in person.
- Let's talk a bit about the basics. What is a prescribed rate loan, and how does it work for income splitting?
- OK. So a prescribed rate loan basically is a loan between spouses. The purpose of it, as you said, is to split income. And the reason that you want that is because there's something in the Income Tax Act called the attribution rules, which basically means if I earn $100,000 and I deposit it into an investment account, even if it's joint with my husband, if that $100,000 earns 5%, that $5,000 income accrues entirely to me because I earned the income.
So we look for ways, legitimate ways and allowed ways, to basically split that income so we're paying on that investment income at lower rates. And the way you do that is the Canada Revenue Agency basically releases the prescribed rate, which is based on the three-month average of short-term Canada T-bills. And that rate, you can consider it as the lowest or pretty much the lowest rate that you can lend money and still have it be a valid loan.
So the way this income splitting works is if I then lend that $100,000 to my husband and he invests it, as long as he pays me interest back at the prescribed rate, he can declare the rest of that income at his marginal tax-- at his tax rate. And hopefully, his is lower than mine so we end up being able to split the income.
- OK. So I'm going to say this back to you. So two spouses. One has a high tax rate. One has a low one. The high-tax-rate person lends money to the person. The other person pays them interest, but then they get the income or dividends, whatever, the investments under theirs. And it's more tax-efficient that way, right?
- Exactly. Exactly.
- OK. Tick. I got an A on that one.
- You did.
- Let's talk about that example you use, which is great. Maybe you can talk a bit about the change in rate that has happened, what people need to think about.
- Right. So in Q1 and 2 of this year, the rate was at 1%. And then in Q3, it went to 2%. And now in Q4, it's going to 3%. And so that's significant because in the example that I gave of the $100,000 to my spouse, let's say I was at a 50% tax rate, my spouse was at 25%. If I invested that money and got a 5% return, so $5,000 of income, and I paid it at 50%, I would end up basically being left with $2,500.
If I lent it to my spouse-- and let's say he's at a 25% rate-- on that $5,000, he pays $1,000 to me. And let's say the interest rate at the time-- I did it early in the year. It was 1%. So let's say he pays the $1,000 to me. I declare it on my income tax return. I'm left with $500 because I'm at the 50% rate, but my spouse basically can declare the remaining $4,000 at his 25% rate. He's left with $3,000. And combined, we now have $3,500, whereas before where I was doing it alone, we had $2,500.
So in that example, what's important? That spread between his tax rate and mine. And then there's a number of other considerations that you also have to think about.
- So at 1%, it was a bit of-- everyone should do it. It makes a lot of sense. The higher the interest rate goes, you really do need to see that spread between the spouses to make it all work. OK. So the spread between the different tax rates between the two spouses is one thing. The next thing, you say, is consider future income of both spouses.
- Exactly, because these types of tax planning measures make sense when the spread between the tax rates between the spouses is significant. But as we're getting closer to retirement, perhaps, you have to reconsider whether this makes sense. Because a lot of times in retirement, we may have other options available, such as pension splitting, that bring our tax rates closer together.
You also have to consider, where is this money coming from? So for example, if it was from a long-term investment that I had and I had to liquidate it in order to make the loan, then I'm triggering, perhaps, capital gains that I then have to pay tax on before I even do this. So then you have to factor in, how much tax savings do we need to have before we get back to zero and then actually start saving because we've triggered this gain?
There's also actually fees involved because this has to be a proper loan. So there has to be a loan agreement. There has to be terms in the loan. You have to make sure that the money is paid back, so there may be legal fees. There may be accounting fees. So all of these things have to be factored in as to whether it makes sense at 3%. And as well, that investment return needs to be pretty high too.
- Yeah, which is funny because-- I mean, not funny. The markets have been tricky over the past little while. So lending money to a spouse and not having an investment make money to begin with, that's a lose-lose proposition, I think, on that side too.
- Exactly.
- Are the legal fees and the accounting fees, are they significant to set something like this up? I mean, can you just write a piece paper? I'm going to do this to you, and just--
- Well, no. I'm not going to say that they are overly significant. Having said that, it's not really something that is meant to be done around the kitchen table. This is sophisticated tax planning. And in discussing the different variables we just talked about, you need somebody to make sure that they've looked into that for you. So it is important to make sure you get the right professionals in place to do it. Yes, it is a fairly simple loan agreement, but it depends on the build-up to that.
- Yeah. That's why we have Georgia here. That's why I am not doing this for you. Someone like Georgia can. Let me ask you-- I know you mentioned this is an interesting thing to keep in mind, too, for funding things like school expenses, grandkids expenses, private schools, those types of things, extracurriculars. And that involves a family trust. And maybe tell me just how that could work.
- Mm-hmm. So a lot of times, we have these family trusts set up, but maybe they're not making a significant amount of income within the trust. It depends on what the value of assets is in it. And especially when you get to the stage of a lot of family trusts when the younger beneficiaries-- and I call it the sweet spot when they're 18 to 24 and maybe in higher education, but they're not really earning their own income-- you kind of wish that the trust was making more money than it was.
So you can use a prescribed rate loan by actually lending money to the trust at a prescribed rate, same idea as before. And that way, you get more assets into the trust that are then generating income that you can flow out to those beneficiaries. The alternative-- you can't just sort of dump money into a trust. That has all sorts of tax problems. But if you do it through a prescribed rate loan, you can actually have the same result and get that trust maybe earning more income during that time, that sweet-spot time, as I say, when you really need it.
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