According to a study done earlier this year, Canadians are expected to transfer in excess of $750 billion to the next generation over the next decade. In many instances, however, the recipient of that inter-generational wealth transfer faces unanticipated consequences with this type of windfall. Quite often, beneficiaries are not prepared for the impact on the family tax bill. This is not due to any inheritance tax - there isn’t one in Canada - but because of the requirement of the beneficiary to pay taxes on any income generated from the investments made with their inheritance.
Currently, Canada Revenue Agency restricts income splitting through the Income Tax Act’s attribution rules. This is an issue. You can’t simply just give your spouse money to invest, or make the ownership joint to try to lower the overall marginal tax rate. In such situations, the investment income would be “attributed” (in essence, given back) to the individual who inherited, and so taxed at their higher marginal rate.
There is a way, however, to reduce the taxable impact. One of the most effective strategies that can be used to address this issue is to loan the funds to the lower income spouse or other family member. In this low interest rate environment, this is both a legitimate and tax effective way to split the income.
HOW DOES IT WORK?
Jim’s widowed mom has passed away. As the last survivor of the marriage, she passes her assets through to her son Jim, and the estate settles. Jim now has $500,000.00 of additional assets available to invest, however he and his wife Diane are concerned about the tax implications given that Jim is in the higher tax rate of 45%. They consider investing the funds in Diane’s name as she only works part-time and is therefore at a lower marginal tax rate of 22%. However, as she is not the intended beneficiary, the attribution rules apply and Jim would still end up paying the tax bill at his higher marginal rate.
The good news is there is an exception to these attribution rules. If the spouses have a formalized, prescribed rate loan between them through a promissory note on the entire amount of the assets, the lower income spouse can then claim the income from the investment of those assets.
For example, if Jim loans Diane the entire amount of $500,000 at a prescribed rate of 1%, and then Diane invests the funds into a balanced portfolio generating 5% (or $25,000.00), Diane then pays Jim $5,000 loan interest. She also then gets to deduct that same amount as a loan expense. She would pay $4,400 on the remaining $20,000 and Jim would pay $2,250 on the interest income.
Here is how it would look:
While this example demonstrates the overall effectiveness that a spousal loan can provide, it is important to review and assess your situation with an expert advisor to determine whether or not it is a strategy that will work for your family.
At Insightful Wealth Group, our team takes the time to thoroughly understand each client’s individual circumstances and helps them to plan accordingly. With a team devoted exclusively to delivering comprehensive strategies and sophisticated solutions, we invite you come and talk to us about reviewing your personalized plan to determine what will best suit your family’s needs.
As always, feel free to contact us!