The prescribed rate is increasing to 2% on July 1, 2022. If you use prescribed rate loans as part of your tax strategy, this increase could affect your financial plan. Georgia Swan, Tax and Estate Planner at TD Wealth, joins Kim Parlee to look at these changes and how they could impact your plans for income splitting.
Well, if you and your spouse have an income splitting strategy and are using something called a prescribed rate loan tactic as part of that. There's something you're gonna want to know. The rate for prescribed rate loans is going up on July 1st and that could affect your taxes, your financial plan as a whole. And you really do need to know what's happening. Here to tell us what is going to be happening is one of our favorites, Georgia Swan, Tax and state Planner at TD Wealth. She joins us from Barrie. Georgia, How are you?
I'm really good, Kim. Good to see you again.
Nice to see you too. Before we get into this, Maybe just a backup for people who may not know, what are the basics? What is the prescribed rate? How do you use it?
So basically it's a rate of interest that's set by the Canada Revenue Agency each quarter and it's basically tied to the yield on three month government treasury bills. And there's a complicated formula under the income tax act that basically calculates it, but it's been 1% for quite some time with a few little changes. But it is slated to go up in the third quarter of this year to 2%. The reason that we're concerned about that, or talking about it, is because, as you said, it is an integral component of a very common tax planning technique that's used for income splitting, called a prescribed rate loan, and you use that loan- Just maybe give us a little background to how. You lend your money to your spouse in a way to help you do some income splitting.
But how does that work? Just briefly.
Okay, well the income tax act basically has a general premise that it likes it when the person that actually earns the money is also the only person that benefits from it, and it's basically done through a series of rules called attribution rules. But if you want to get around those attribution rules, let's say for example, I am the higher income spouse, and let's say I earned $1 million dollars one year. If I basically invest that money, even if it's a joint account, any investment income will get attributed back to me because I earned the money. But if I have a spouse that is in a lower tax bracket, perhaps they're a stay-at-home parent or they have a job where they just earn less money. A way of tax planning between the two of us would be to get some of that income into my spouse's hands. So overall we reduce our tax burden. And the way you do that is through a prescribed rate loan where, in actual fact, if I earned that million dollars, I will loan that money to my spouse, and my spouse will invest it. And in that way, that investment income will be taxed in the hands of my spouse, instead of attributing back to me. But that loan has to be real. There has to be a loan agreement. There has to be terms and it has to be at the prescribed rate of interest at the very least.
Why would you want it to be more?
So basically if the loan is given at the time that the interest rate is 1%, only 1% of interest needs to be charged. But that interest must be shown to be paid. So the recipient spouse has to actually-- if you're part of my generation, cut a cheque for the interest, either let's say its interest for 2022, it has to be paid in 2022 or by January 30 of 2023, and you have to see that money changed hands. So whether it's by e-transfer or a cheque, it has to go. So that's the important component of this. The interest, the prescribed rate of interest in the quarter that the loan is made is the interest rate. That is basically going to be the interest rate for the entire outstanding term of that loan. However, now that it's going up, if you're planning on doing this type of planning, you need to get a move on because as of the third quarter, so July 1, 2022, it's going up to 2%.
Got it. Okay, so just again, just one more high level thing. If you can lend your money to a spouse for 1%, they can generate 4%, you've got a 3% difference. As long as you can document this is actually being lent and paid and that type of thing is going in there, and you need to lock it in now. What do you need to be thinking about?
If you say this applies to me, because going from a 1% prescribed loan to 2%, some people may say that doesn't sound like a big jump, but it's double. So what do people need to do now to make sure they can lock this in and be prepared for this when it happens?
Okay. So first of all, if you're contemplating it, but don't have something in place, then you need to get moving, you need to go to your lawyer, documents need to be prepared and the loan has to be properly papered, and then actually there needs to be a trail of the funds if you have it in place, but you're contemplating changes to it. That's another reason to actually get it done now. For example, if you did this a year ago at 1% and now you've decided you want to learn a little bit, more. you should still not wait because any additional amount loaned is considered a new loan and there are tax consequences to that potentially because the old loan has to be paid back and a new loan has to be created. You can't just add to an existing loan at 1%. So that's the importance. The other thing is, it may not look like a big jump when it's 2%, but you have to take into account what return you're getting on that investment. You want that spread to be as high as possible. And it really makes a difference depending on what kind of an investor you are. If you're an incredibly safe investor, now I'm not an investment advisor, but if you're a safe investor that gets a lower return for that security, 1% difference, going from 1% to 2%, could have a huge impact on the benefit of this type of planning. So it's really important to talk to your investment advisor and, like I said, we're giving you now just a little bit over a month to get this this stuff in place. So it's time to move because we don't know if the next quarter, the interest rate is going to go back down or perhaps even go higher. So get it now while it's at least still at 1%.
Yeah, that's a good point because right now the direction of many interest rates we see on this one do seem to be pointing in an upward direction, so it's something to keep in mind. Georgia, thanks so much for this.
Thank you, Kim. Good to see you again.