Spousal Loans: How Do They Work?

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The idea of one spouse lending funds to the other might seem strange. Why would you loan your spouse money if you vowed to be together for richer and poorer? Actually, some couples may find it a great tax strategy. Income splitting strategies may offer a large advantage to households where two partners earn drastically different incomes. 

Splitting income may also lead to a big decrease in overall income tax. However, this strategy may not be suitable for everyone. Here is what you should consider when thinking about setting up a spousal loan.

A Form of Income Splitting

There aren’t many ways to even out a household income other than pension splitting. When one spouse earns drastically more than the other, a few deductions and credits may be transferred at tax time. 

However, not much can be performed to lower the higher earner’s tax bill. What can you do? A spousal loan can be of great help. When you urgently need additional money for a couple of weeks, you may take out payday loans no credit check instant approval 24/7 but you face responsibility for this decision.

Similarly, a spousal loan is one income-splitting strategy that demands careful consideration. It’s necessary to admit that income-splitting strategies may not be suitable for every household. Some methods can even lead to higher income tax if conducted in the wrong circumstances, while others might be easier to execute. 

Some people are tempted to utilize every available method to try to reduce their overall income tax rate. Yet, particular methods demand careful consideration, and a spousal loan is one of them.

How Do Spousal Loans Work?

The basic idea behind spousal loans is quite simple. What is the goal of this lending option? It is that non-registered investments accrue investment income in the hands of the smaller income spouse instead of the higher income spouse. In order to realize why a spousal loan may be a decent tax strategy, you should know how the Canada Revenue Agency (CRA) treats exchanges of funds between spouses. 

A spousal loan should be set up to transfer money from the higher income spouse to the lower income spouse. As you can see, the main idea of this lending option is simple but you should keep in mind some considerations as each particular situation is different.

Have You Tried Other Methods First?

According to The Navigator article by the Wealth Management, some people may be searching for ways to lower their family’s overall tax bill, especially with the recent increase in tax rates. The spousal loan strategy is a method of income-splitting that might help couples to reduce their overall family tax bill by choosing a prescribed rate loan arrangement. 

Who can benefit from this arrangement more? It is generally beneficial for couples where one spouse has significantly more taxable income than the other.

On the other hand, you should consider other strategies before you decide if a spousal loan would be beneficial for your household. Although you may feel tempted to set up a spousal loan straight away to lower your overall household tax bill, try to execute other income-splitting methods first. You might want to try and set up this loan yourself, but most often you will need qualified assistance. 

Executing some other income-splitting strategies may help to reduce your household income tax bill as well so that you won’t need to turn to the spousal loan. More than that, try to maximize your tax advantage accounts in the first place. You should maximize RRSP and TFSA before you invest in a non-registered account.

Charging Interest

Interest is one of the most important elements of a spousal loan. You should charge your spouse interest on this lending option and this interest must be at least as much as CRA’s prescribed rate. The prescribed interest rate remained at 1% for the past several years so you must charge at least this rate. The interest should be paid by your spouse on time to remain within the regulations of a spousal loan.

However, you should bear in mind that the principal doesn’t have to be returned, only the interest. As long as the demands of a spousal loan are met and the interest is charged and paid on time, any income earned by the investment is assigned to the borrowing spouse at tax time. It can be a beneficial strategy that will bring you substantial savings in the long run.

What You Need to Do If You Decide to Set Up a Spousal Loan

  • Make certain the spousal loan is documented correctly. It should include repayment terms just like any other lending option.
  • Charge interest that is not lower than the Canada Revenue Agency’s prescribed interest rate (this figure is currently 1%). Until the lending option is paid back, the rate should be locked in.
  • Ensure your spouse who obtains the loan pays this interest. It should be done regularly and on time (annually or within 30 days of the end of the year). The other spouse will have to deal with the Attribution Rules in case of a missed or late payment. What does it mean? The income generated by the loaned funds is to be attributed back to the spouse who lent the funds that year and in the next years.

The Bottom Line

How can you decide if a spousal loan is right for you? It depends on a certain situation of a couple and the type of income they earn. Depending on the income you get in your non-registered account, this lending option can be a great fit for you. 

On the other hand, there are some downsides so it’s necessary to consult with a qualified professional. Turn to a specialist if you consider advanced income-splitting methods like spousal loans. A lawyer can help you make a loan agreement and offer relevant advice so that you understand how this loan fits within your general financial strategy.

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