By David Milstead
Source: The Globe and Mail
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For professionals with their own small businesses, an alternative retirement plan can offer big tax advantages over RRSPs
Carl Jacobson hasn’t put a dime in an RRSP in three years. And he wouldn’t have it any other way.
He’s still saving for his retirement. But the Vancouver lawyer has rejected the conventional wisdom that he should take a salary from his business and maximize his RRSP contributions.
Instead, Mr. Jacobson has found his greatest tax advantage lies in paying himself through dividends, not salary, and leaving the money that would normally go into a RRSP in his corporation, where it can be reinvested.
“I’m looking at my company as a place to save – that’s my retirement nest egg,” he said.
Mr. Jacobson’s financial adviser, John Nicola of Nicola Wealth Management, recommended the alternative strategy to him. And he recommends it to other professionals who have incorporated their businesses, including lawyers, accountants and consultants.
“There’s no significant difference to an individual’s income between salary and dividends in most cases,” Mr. Nicola said. “But when it’s tied into these other issues, all of a sudden, the difference becomes dramatic.”
The strategy gained added clout last week with the release of a report by CIBC that confirms Canadian small business owners may be better off in retirement if they follow this strategy.
“Business owners may end up with more money after-tax by funding their personal living requirements with dividends and leaving the excess cash in the company,” said Jamie Golombek, CIBC’s managing director of tax and estate planning. After crunching the numbers in a specially built model, Mr. Golombek found that in every province other than Quebec, the strategy left business owners with more after-tax cash.
Here is how it works:
Under the old scenario, the owner-manager of an incorporated business took a salary from the business (high enough to provide maximum RRSP contribution room) and paid personal income tax on it. He might also have split income with a spouse by paying them a salary.
Under the new scenario, the owner-manager pays himself dividends, rather than salary, taking enough to fund his personal living requirements but leaving the excess – which would have gone into RRSPs – in the business, where it is invested. He pays income tax on dividends at an effectively lower rate, while the income left inside the business is taxed at the small business tax rate. The combined total tax using this strategy, said Mr. Golombek, is lower than the personal income tax paid in the first scenario. (See the accompanying example for a breakdown.)
Then, “at retirement, instead of withdrawing funds from an RRSP or RRIF to live on, the business owner would sell corporately held investments and extract the after-tax proceeds as a dividend,” said Mr. Golombek.
Mr. Jacobson, as a business lawyer who does incorporations, thought there would be an advantage to taking his income this way, but hadn’t taken the plunge until Mr. Nicola’s firm showed him the long-term implications. “They had run the math and thought through some issues that I knew were relevant, but didn’t have the time to crunch out,” he said
John Groenewold, a Vancouver accountant who uses Mr. Nicola’s firm for certain financial products, has used the dividend strategy since he incorporated his business in 2003. He says it allows greater flexibility to split income between spouses, since Revenue Canada may look askance at some salary divisions between spouses at a small corporation.
Another significant benefit, in his eyes, is avoiding paying premiums to the Canada Pension Plan, especially since entrepreneurs have to make both employee and employer contributions. “That’s a big one that people should really consider … I think you’re better served by investing that money yourself in your corporation rather than giving it to the government and having them manage it for you,” Mr. Groenewold said.
Finally, whereas RRSP contributions must be transferred to an RRIF and withdrawals begun at a set age, dividends offer more control over when the business owner actually gets – and the taxes he pays on – his savings
As with most tax strategies, however, the benefits come with some caveats.
Mr. Nicola stresses this is not a cookie-cutter solution to the tax problem. If the company’s pretax income exceeds $500,000, it may be better to revert to the salary strategy, because corporations that exceed $500,000 in taxable income pay a higher rate – 29 to 33 per cent, depending on the province, versus 12 to 19 per cent. (Some provinces begin taxing businesses at their higher rate at the $400,000 threshold.) Business owners should consider paying themselves salary up to the level where RRSP contribution can be maximized, roughly $122,000.
There are other important considerations: In many cases, an ideal corporate structure for this tax strategy would involve an operating company, a holding company that would store the retained profits, and a family trust to provide further protection. A trust allows creditor protection of assets, the potential of earning a multiple of capital gains exemptions for multiple beneficiaries, and the ability to split income among family members without giving them share ownership.
Clay Gillespie, managing director of Rogers Group Financial in Vancouver, points out that RRSPs and Individual Pension Plans have greater protection from creditors than corporate assets.
And, although he likes the strategy, he notes it could be derailed by human nature. “People tend to spend money they can get their hands on,” he said, as opposed to dollars socked away in tax-advantaged retirement plans. “It’s whether people will be disciplined enough to take the money and invest in a way to take advantage of the strategy.”
It’s particularly important to make sure retirement savings are sacrosanct, given that future CPP benefits (but not benefits accrued previously) will be lost under this strategy.
Finally, while this structure works for professionals, whose major asset is their own labour and intellectual effort, it’s probably not wise for a manufacturing company or more-tangible business that could be sold for a substantial career-ending payoff. “It’s more incumbent on a professional to build wealth,” Mr. Nicola said.