Spousal Loans – The Case of Dr. Strange

A spousal loan is one of many strategies for income splitting. We examined how a spousal loan could help Professor Jones, a high-income employee, and his wife reach towards their dream of early retirement and adventure. In this post, we’ll get a little more complex. Brain-surgery complex. How well can a spousal loan work for an incorporated professional? Will the benefit of a spousal loan outweigh the tax hit from removing extra money out of the corporation?

Meet Dr. Strange, Incorporated.

Like the neurosurgeon in the Marvel story, Dr. Strange is a high-earning physician. Unlike the womanizing jerk-wad Dr. Strange in the Marvel movie, this one actually gets married. He has a lower income earning spouse that he wants to income split with.

Dr. Stephen Strange – Our Base Case

Household income & cashflow.

Dr. Strange is an Ontario surgeon who earns $450K/yr and draws a $250K salary from his CCPC.  His spouse makes $30K/yr. This Dr. Strange also does not drive a Lamborghini, and with the savings the Stranges’ have enough cashflow to max out their TFSAs and RRSPs. They have also decided that a taxable personal account will be part of their retirement planning. Dr. S decides to pay out an ineligible dividend of $147K from his CCPC which gives him $100K after tax to lend to his spouse at 1% interest. She invests it via her personal account in a Canadian market tracking ETF that pays 2.8% in dividends and they expect it to make 5% capital gains per year on average. We guess that the average annual inflation will be 2% to adjust values into “current” dollars over time.

The tax savings of investing using a spousal loan.

Accounting for taxes at her lower marginal rate and his taxes on the 1% loan interest, they pay $143 in tax on the $7800 investment income. This compares to $1102 if Dr. S invested via his own account or in a joint account and the income gets attributed to him. [The calculator screenshot above lists Joint account as an option to compare strategies if they have similar incomes where a joint account is more appropriate than a spousal loan strategy]. Attribution rules still apply to joint accounts, but the calculator assumes equal contributions to the account by each spouse in that case.

With Mrs. Strange’s dividend tax credit, she pays less tax on her earned income and re-invests those savings. This gives her portfolio a tax bolstering of 0.19% instead of the tax drag on returns of 1.10% in her husband’s hands. That tax bolstering or drag can change as the investor earns more dividend income and moves up tax brackets. In this example, Mrs. S moves up a bracket right at the end of the 25 year period which is why the average tax bolstering is 0.18% in the above chart. Dr. S is already in the highest bracket, so there is no change in tax drag over time for him. The calculator automatically tracks this in the background.

What does that look like in 25 years?

This spousal loan of $100K grows into a taxable account of $674K after 25 years in nominal dollars which is $420K in “current” dollars adjusted for inflation. For comparison, it would be $292K in “current dollars” when invested in her higher income husband’s hands. That is $128K or 45% more using this income splitting technique. Behold! The powerful effects of tax drag on the compounding returns of a portfolio over time!

An important caveat about the interest payments.

The above calculation, does not include the interest drag caused by paying 1% interest on the loan which you normally would when considering returns on an investment loan. Some would argue that this is ok because that money is being paid back into the household rather than an external bank. However, if the only way Mrs. Stange could afford to pay that $1000 interest would be to use her investment income or decrease her deposits into her portfolio by $1000, then you should include the interest drag. That % interest drag will decrease over time as the portfolio grows while the interest payment never changes. Further, the effective drag is less when you account for the fact that the interest is deductible against income for taxes and while the interest payments stay the same, they decay in terms of real value as inflation makes the nominal dollars less. In this case, example, the interest drag is 1% the first year and decays to 0.26% by year 25. The spousal loan calculator accounts for all of this and shows that the portfolio would actually be only $375K or 30% more compared to Dr. Strange investing when the loan interest is factored in. Personally, I would count the interest drag because we protect all of my wife’s income to invest in her name and the $1000 she would pay in interest is money that otherwise she would have invested in her account.

That loan interest drag decreases some of the benefit of the strategy.

It isn’t just about accumulation. Accessing early retirement income is improved.

The benefit of a spousal loan strategy is not only during the accumulation phase, but also during the draw down phase. They can access the money taxed at her lower rate. Let’s explore that below.

They decide to retire early for Dr. Strange to pursue his childhood dream of becoming a sorcerer who saves the Universe. They need to access money from the taxable account as part of their draw down plan. Mrs. S draws $30K/yr from her RRSPs to start melting them down. Dr. S draws $100K from his passive investments in his CCPC (this would be capped at about $50K/yr under the proposed rules, but we’ll assume he had some grandfathered investments also). Mrs. S draws 4% from her taxable account which is $17K/yr. After taxes they have $127K/yr. If you include the loan interest drag, then even though her portfolio size is smaller, her low tax rate still results in them having $126K/yr compared to only $119K/yr that they would have if Dr. Strange had invested instead. This improved withdrawal tax efficiency would continue until they hit age 65 and could split dividends from their corporation. 

Effect of an increase in the prescribed interest rate

The prescribed interest rate will likely go up to 2% in April. That doubling of the interest rate increases the taxes paid by the higher earning spouse on their income from the loan. However, it also increases the amount of investment income that the lower income spouse can deduct the interest against further decreasing the tax drag. In our above example with the Stranges’, it would increase the portfolio value by about $130K if the lower income spouse re-invested their increased tax savings over 25 years. However, it would also mean that the higher income spouse would pay an extra $500 in tax per year. Because the lower income spouse has some earned income to write off with their tax credit generating laughter yoga dividends, the net effect is actually still a lowering of their overall household tax bill and essentially more income splitting. That net benefit would be lost if the lower income spouse did not have enough taxable income to apply the tax credit against. Another good reason to hire and pay them to work in the business.

The biggest damage to the spousal loan strategy due to a higher prescribed interest rate is if you need to the count the loan interest drag on the portfolio return. If the lower income spouse is investing all of their income in their taxable account with the higher income spouse paying all living expenses (the recommended approach), then you need to count the loan interest drag. This is because the money that the lower income spouse has to use to pay interest on the loan is money that they are not investing. The good news is that the effect of that interest drag decreases as the portfolio grows in size. In this example, the interest drag on returns is 2% in the first year and decays to 1% by year 15, and is only 0.5% by year 25.

Further, when you account for the improved tax efficiency of withdrawing funds in the lower income spouse’s hands, then the strategy still results in $5K/yr more after-tax household income. Not as good as the $7K/yr difference with a 1% interest rate, but still not chump change.

What about building income/interest generating assets instead of eligible dividend generating ones?

Generally a non-registered taxable account is not where you’d want to have tax inefficient investments that generating income that is taxed at the full marginal rate. Having it sheltered in an RRSP is usually the best option. There are a variety of ways to invest that generate income such as real estate, bonds, and other debt obligations. Some can be complex, but can also have a variety of other benefits for generating net worth and diversifying a portfolio that are beyond the simple modelling here. Dr. Networth has some good articles in his blog on passive (less work and no plugged toilettes) real estate investing in Canada.

However, for the sake of a direct simple comparison, let’s say that the Stranges’ go for an interest bearing investment (eg. bond/loan) at the same rate of return (7.8%) as the above Canadian dividend paying ETF example. They lose the tax advantage of the dividend tax credit and income is taxed at full marginal rates. This results in a net tax drag of 4.18% in the hands of the higher income spouse, 2.87% if they have joint attribution, or 1.36% if attributed to the lower income spouse. The effects of this are profound.

Because of the tax inefficiency of interest/income, they have a much smaller nest egg regardless of the investment holder. However, in the lower income spouse’s hands it is still about 75% more in value after 25 years compared to being taxed in the higher income spouse’s hands. Tax inefficient investments really take a beating when taxed in a higher income spouse’s hands. Big shocker there.

What about the opportunity cost of taking money out of the CCPC to make the loan?

If Dr. Strange just happened to have an extra $100K in the crack of his couch or in the “found money” section of his washing machine, then no problem. Similarly, if he were a high paid salaried professional who did not have the option of leaving retained earnings in his CCPC as passive investments, then it would not be a consideration.

However, Dr. Strange has his excess cash in his CCPC and would need to give himself a dividend of $147K to have $100K after tax to loan to his wife. If he had left that money in the corp and passively invested in the same ETF, would he have more? He would have more money invested initially. However, the tax on dividends in a CCPC is 38.33% (ouch) and passive investment income 50.17% (super-ouch). So, the rate of growth of the portfolio is less due to tax drag of 1.07% in this case. This results in a portfolio value of $466K in “current” dollars after 25 years which is more than the $420K from the spousal loan strategy and much more than the $375K when you account for the interest drag.

Money in a corporation is tax-deferred. You still pay tax, whether now or later.

But wait! Contrary to the rhetoric, passive investments in CCPCs isn’t really tax dodging, but rather tax deferral. The money has to come out as ineligible dividends and be taxed accordingly to be accessed.

Since they are under age 65, Dr. S can only give dividends to himself and is taxed at his higher rate. Under the current rules, while his investments have been taxed at a higher rate in the CCPC, they have also been generating money in a Capital Dividends Account (CDA) and Refundable Dividend Tax On Hand (RDTOH) account from which he can give himself tax-free dividends. This amounts to $67K in “current” dollars in our example plus another $4K annually moving forward. Alternatively, that RDTOH/CDA accounts could have been refunded yearly when giving non-eligible dividends from his CCPC – that would lower the effective tax drag on a CCPC portfolio. Using the same RRSP and investment withdrawal rates as our spousal loan case, he takes $10K/yr in capital dividends and $5K/yr as ineligible dividends resulting in an after-tax household income of $123K/yr. That is $2500/yr less than the spousal loan strategy.

So, in this example, it was marginally worth paying some extra tax now taking money from their CCPC to implement the strategy for the future. It is very close and I would consult my tax planning professional for the nuances of my own case before implementing.

Growing a “too-big” corporation could change the math.

If a corporation starts to generate a lot of passive income, it can become tax-inefficient. For example, if may need to pay out extra dividends to release RDTOH that is collected at roughly the highest personal tax rate. If you exceed the active-passive income limits, then corporate tax rates jump. You can pay more corporate tax or move more money out of your corporation and pay more personal tax. Moving more money into personal hands may help to delay or attenuate the effects. A spousal loan could then decrease the personal taxes moving forward.

What have we learned from this case:

• If all you need is what you save in your TFSAs, RRSPs, and CCPC , then a spousal loan for a personal account may not be needed. If you need more space, requiring a taxable investment account, then a spousal loan may be worthwhile.
• It can result in a larger nest egg due to decreased tax drag while accumulating.
• If accessing the funds before age 65, withdrawing funds from a taxable account in the lower income spouse’s hands makes it even better.
• A higher prescribed interest rate for spousal loans lessens the effectiveness of the strategy, but only by a little when there is a spouse in the highest marginal rate and one in the lowest.
• The decay of the loan interest drag on returns over time as the portfolio makes compound returns plays a big role in whether the strategy is worthwhile, so being proactive and starting early is key. This gets more important as the prescribed rate is likely to rise further in the future.
• Investments that generate some eligible dividend credits and capital gains are better in a taxable account than tax inefficient investments that generate fully taxed income. However, if you did that, a spousal loan can make a huge difference.
• There is opportunity cost for taking money out of a CCPC to make a spousal loan. In the above example, it was worth it (barely) if you have the same investment types in either strategy. Dr. Networth in the comments on the original article pointed that if you use a specific non-dividend (cap gains only) producing investment then it may be closer. It is probably a wash with the current rules and I would suggest consulting with your tax planner if considering this strategy. Please see the discussion the comments section.

This example was a case with a doctor in the highest tax bracket, a CCPC, and low income spouse. What about the vast majority of the population?

There are many professionals and business people with excellent incomes in the middle tax brackets. They also don’t have the considerations of a CCPC. Can they benefit from a spousal loan? We look at that situation in the related post, when we Meet the Jones’.