Lend your kids money; Prescribed-rate loan reduces tax on investments
Many post-secondary students will begin their new semester of university or college this week and for some parents, the additional burden of wanting to assist their kids financially could put a severe dent in their monthly budget during the eight months ahead.
Last week's column discussed strategic RESP withdrawals. Parents often find, however, that those funds may not be enough and end up supplementing RESPs withdrawals with additional aftertax cash support to the kids.
What if there was a way to help your kids out with school but to do so on a pre-tax basis? Consider a prescribed-rate loan strategy.
You'll recall that under the Income Tax Act, if you simply lend your kids money to invest and don't charge interest on that loan, any interest income or dividends earned on those funds is attributed back to you and taxed in your hands, at your marginal tax rate.
On the other hand, as long as you charge the prescribed interest rate, any income you earn above that rate can be taxed in the child's hands. If the child has minimal or no income while they are in school, the tax payable on any excess return earned above the prescribed rate charged on the loan can be substantially reduced and, in many cases, may be eliminated altogether owing to the various credits (basic, tuition, education, textbook) a student could claim.
There is no better time than now to set up such a loan because the prescribed rate, which is calculated based on the average yield of 90-day T-bills sold during the first month of the previous quarter, has been fixed at 1% until Sept. 30, 2012. That's the lowest rate it's ever been and it can't get lower since the rate is rounded up to the nearest whole percentage point.
The best part of executing such a loan before Sept. 30 is that the rate can be fixed for the duration of the loan. In other words, even if the prescribed rate goes up over the next few years while your kids are in school, you can still use the 1% rate for as long as the loan is outstanding because the tax act only specifies that you charge the rate at the time the loan was originally extended. That's why in practice many such loans have no specific term on them and are simply payable "on demand."
The only obligation is for your child to pay you the 1% interest on the loan by Jan. 30 of the following year. The interest paid is deductible to your child and reduces the taxable income from the investment but it's taxable to you. The net benefit, therefore, is simply the tax savings realized annually from having any excess returns above 1% taxed in your child's name, instead of yours.
Practically, many parents who set up such loans do so by lending the funds to a family trust, in which the child is merely the beneficiary and can't exercise control over the funds being invested.