Previously, we took a very detailed look at how spousal loans work for intermediate-term income splitting. I then used the example case of Dr. Strange, a high income earning surgeon with a profesional corporation (CCPC) to explore some of the considerations. This blog is aimed at high income earning professionals which is why I used that case. However, I am also very cognizant of the fact that many professionals don’t make those incomes and many may even be primarily salaried.
While the numbers may be different, the principles that I am talking about on this site apply to a wide variety of professionals. I wanted to spend some extra time in this post using spousal loans as an example of that. I have used the excel-based spousal loan calculator to come up with the numbers in our example. You can download it and open with Excel to run your own numbers if you want.
Meet the Jones’
Let’s look at Professor Jones. He is a University employee who teaches history and earns a more down to earth (but still way over the Canadian average) income of $130K/yr while his wife earns $30K/yr working part-time as a free-lance writer. They live frugally and max out their TFSAs. The Prof has a University pension which he could take early at a reduced rate of $50K/yr if he retires at age 55. They dream of early retirement to “slow travel” around the world while they are still physically able to pursue some of their more physically strenuous hobbies. Even with his pension, they will need to sock away money in a taxable account in addition to their registered accounts to be able to pull it off.
To boost up his wife’s personal investment account, the good professor gives her a spousal loan of $50K at 1% interest. They invest it in an portfolio that will return 2.8% eligible dividends and 5% average capital gains (which they don’t cash in) per year. She gets a refund of $196 because of the dividend tax credit and Prof. Jones pays $217 income tax for his interest income from the loan. This means they pay $21/yr in tax now for the boosting of Mrs. Jones’ invested assets by $50K. Not bad. Even better though is that if Mrs. J takes her tax refund and re-invests in in the account while Professor Jones pays any taxes owing, then account grows with a tax bolstering of the return by 0.39% which slowly decays as she moves up tax brackets with an average bolstering of 0.19% over 25 years.. This compares to a tax drag of 0.71% if the Professor invested in a personal or joint account where the income would be attributable to him. This small tax drag advantage results in a difference in portfolio size at 25 years using the spousal loan strategy of $27K more money. Note that all of these amounts are adjusted for 2% annual inflation to give values in “current” dollars rather than the larger “nominal” dollars. This is summarized below.
Embarking on the new adventure
After 25 years, Professor Jones decides to hang up the hat. Actually, he picks up his trademark hat (and whip) and he and the Mrs. quit their jobs to travel the world in search of lost treasures. They always seem to lose any treasures that the find in the end, so are dependent on Prof. Jones’ pension of 50K and Mrs. Jones draws money from her RRSP and taxable account to supplement their budget.
As you can see, due to the larger account size accrued with lower tax drag, they should have ~2K more income per year with the spousal loan strategy. Now, in this case, they are both in similar and relatively low tax brackets for the drawdown phase. So, most of the $2K net income difference is due to the account size ($1500) rather than tax efficiency on withdrawal ($500). This is in contrast to what we saw in our previous high income example of Dr. Strange where tax efficiency on withdrawal was also very beneficial.
What happens if they did not use this strategy before April 1st when the prescribed interest rate likely rises to 2%?
Well, unfortunately, much of the benefit of the strategy is lost due to the increased interest drag on the portfolio. As you can see below, the portfolio would only be $12K more after 25 years.
When they access the money, there is only about a $600/yr advantage with a safe withdrawal rate of 4%. Is that worth it? Well, part of that depends on how long the Jones’ survive in retirement. Over ten years, $600/yr is $6K. If they retire at age 55 like in this example, they could easily have a 30yr retirement which means $18K in spending money over their lifetimes. Of course, I am pretty sure that life expectancy calculators do not account for the risk of death from the Jones’ retirement past-time…
What can we learn from this example?
- A spousal loan may be a useful strategy at the current ultra-low interest rate of 1%, even for an employee earning a good, but not astronomical income. The effect is less than with an ultra-high income earning professional. However, the likely costs of their lifestyle is probably lower since they live within their means already.
- Given the thinner margin, there is a bigger effect of loan interest drag on performance. When rates go up to 2% (as they soon will), there is only a marginal advantage.
With Dr. Strange and Professor Jones we have looked at two high income professionals in very different situations. Income splitting with a spousal loan is more effective in some cases than others and that effectiveness is influenced by a number of factors. The spousal loan calculator helps to automatically adjust for those.
How would a spousal loan work in your situation?
Try downloading the spousal loan calculator to run your numbers and think about it.