With the coming rollback in the TFSA limit, high-income Canadians are on the lookout for new strategies to help reduce taxes on investment income.
One option is to use a prescribed rate loan.
A legal way to avoid attribution
Low interest rates have opened up an opportunity for families to use an income-splitting strategy that gets around the attribution rules.
If a person gives money to a spouse or child to invest, the gains on that money are attributed back to the family member who handed out the cash.
The Income Tax Act allows you to get around this problem by lending the money instead of giving it. With interest rates at such low levels, the government has set the 2015 minimum or prescribed interest rate of that loan at just 1%.
The demand loan can be made today and fixed for decades at the 1% rate. The family member who receives the loan must pay the interest by January 30 every year. Otherwise, any income earned on the money gets attributed back to the lender.
The strategy is effective when one family member is in a very high tax bracket and the other has little or no income.
A spouse-to-spouse example
Here’s an example of how a family might take advantage of the strategy.
The individual in the top tax bracket gives a $100,000 loan to his or her spouse. The loan is provided at the current prescribed rate of 1% and secured by a promissory note.
The borrowing spouse invests the money in some of Canada’s top dividend-growth stocks. Most of the banks are considered reliable picks and provide yields above 4%. Another long-term favourite, BCE Inc. (TSX:BCE)(NYSE:BCE), offers a yield of 4.8%.
If the portfolio has an average dividend yield of 4.5%, the investments would generate $4,500 in annual dividend income. That easily covers the interest of $1,000, which is paid to the lending spouse. The high-income spouse has to pay tax on the $1,000 interest that is received, but the borrowing family member can deduct the interest payment because the loan was used for earning income.
The family enjoys a tax benefit because the dividend income gets taxed at the tax rate paid by the low-income spouse. This could very well be nil if his or her total income is low enough. Families with a lot of money can actually take advantage of the way the dividend tax credit works and avoid tax on dividend income as high as $50,000 if they live in the right province and the dividends are the only income the low-income spouse earns.
If both parents are high earners, the loan can be given to adult kids.
If the children are still minors, a discretionary family trust is often set up with the kids named as beneficiaries. The loan is then made to the trust at the 1% prescribed rate and the trust invests the money.
Why do it now?
The Canadian government resets the prescribed rate every year, so families have until December 31 2015 to lock in the 1% loan.
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Fool contributor Andrew Walker has no position in any stocks mentioned.