Income Splitting - Spousal Loans

One look at marginal tax rate tables, and you can tell that the more you make the more you pay - not just in an absolute sense but as a proportion of each new dollar earned.  Income splitting is a great way to lower the combined overall taxes paid by a couple by splitting off income to the spouse with the lower marginal tax rate.

Splitting income during retirement can be achieved in several ways:
  • Contributing to your spouses TFSA
  • Pension Income Splitting
  • Contributing to a spousal RRSP
Splitting income before retirement can be even more advantageous since it is possible that the higher earning spouse is paying a higher marginal tax rate now than he of she will during retirement.  You can still contribute to a spouse's TFSA before retirement.  But there are other options.

A spousal loan from the higher earning spouse to the lower earning spouse allows investment earnings to be taxed in the hands of the lower earning spouse, typically at a lower tax rate.  The Canada Revenue Agency allows this with some conditions: 

1. The loan agreement must be documented.
2. The loan interest must be paid by January 30th of the following year.

The rate for the loan is the “prescribed rate” set by Canada Revenue Agency every quarter. The rate has been at a historic low of 1% April 2009.  Interestingly, if you enter into an agreement today, the rate stands for the duration of the loan.

As an example, say the higher taxed spouse (income above $87k) loans $10,000 to the other (income below $39k) to invest in eligible dividend paying stocks yielding 5% ($500 annual earning).  The higher taxed spouse will pay about 43% tax on the 1% interest earned per year, or $43 of the $100 loan interest.  The lower taxed spouse will pay about -2% tax on eligible dividends, a return of $10, resulting in a net earning of $510.  Subtract the other spouses tax of $43 and the combined net earning with income splitting is $467.  Compare that with no income splitting and the higher taxed spouse holding the investment and paying 25% tax, for a net earning of $375.  Income splitting adds 25% more to the net return!  

Although the example above is for eligible dividends, a similar tax advantage exists for other income types.  On "Other Income" like interest from a MIC, syndicated mortgage, etc. the relative gain is higher.  The  lower taxed spouse will pay about 20% tax on eligible dividends, or $100, resulting in a net earning of $400.  Again, subtract the other spouses tax of $43 and the combined net earning is $357.  Compare that to the higher taxed spouse holding the investment and paying 43% tax on interest, for a net earning of $285.  Income splitting again adds 25% more to the net return.  

PS - This strategy also works for loans to a child.  But remember the child legally owns the investment earnings.