Income Splitting for Tax Savings
Income splitting is a term used to describe a method of shifting income from a higher income earner to a lower income earner. In the case of spouses, it is possible to achieve income splitting using a “prescribed rate loan”. The loan needs to be properly documented in a loan agreement. The lower income spouse borrows the funds and invests them.
For tax purposes, it is important that the loan carries interest at the prescribed rate, which has been lowered to 1% since July 1st, 2020. The lower income spouse needs to pay the interest on the loan annually to the higher income spouse, no later than January 30th. If this deadline is missed, even once, the loan becomes “offside” and for tax purposes, all the investment income would be taxed in the hands of the higher income spouse. Therefore, it is important to keep proof that the interest payments were made.
The ‘Fine Print’
This income splitting strategy will only work if there are funds available to invest outside of tax-deferred plans like RRSPs or a TFSA. Also, the tax advantage will depend on two things:
(1) the difference in tax rates between the higher and lower income spouse, and
(2) the rate of return on the capital invested.
Discussing these types of strategies with your accountant will help you understand how it would work within your household. Since there are some details that may be unfamiliar, having a professional opinion will clarify expectations before embarking on your journey. Moving forward with peace of mind will make any strategy you execute more rewarding.
If you’d like to explore income splitting using prescribed rate loans lets connect. We’re the small biz pros for a reason!