What is more tax-efficient for the incorporated small business owner - pay yourself via a salary, pay yourself via dividends, or a combination of the two? At first glance, it appears as though leaving more money in your company might gain you more taxadvantaged money in retirement, but there are many factors to consider.
New theory has gained traction
Until recently, financial planning experts often advised small business owners to pay themselves enough in salary from the corporation to maximize their yearly Registered Retirement Savings Plan (RRSP) contributions in a tax-deferred investment. Your company can deduct the salary as an expense and the money you receive is taxed in your hands at your marginal rate.
For businesses with net income less than the Small Business Deduction Limit ($500,000 federally and in most provinces), a new theory has recently gained traction â€“ take only enough money from your corporation in dividends to pay personal living expenses, leave the rest inside your company, and invest those funds as you would for an RRSP. Although the company doesnâ€™t get a deduction for the dividends it pays, youâ€™ll pay tax on the dividends personally at a lower rate than on a salary and the money left inside your corporation is taxed at the lower small business rate. Following a dividend strategy as opposed to paying a salary, you can have the same after-tax personal income and have more money invested inside your corporation than you would otherwise have invested in a RRSP.
Dividends give you better control
When you retire, instead of withdrawing from your RRSP, you can sell your corporate investments and take the after-tax amounts as dividends. Unlike RRSP contributions, which must be transferred to a Registered Retirement Income Fund (RRIF) by age 71, and unlike RRIFs, which require that you take specific withdrawals, dividends give you better control over when you take your savings and how much tax you will pay. Just ensure you have the discipline to leave those funds invested in the company over the years leading up to retirement.
While there are tax savings in choosing to pay yourself with a dividend instead of a salary, there are disadvantages and issues that need to be considered:
• By switching to a dividend compensation strategy, your retirement income under CPP (or QPP) will be reduced and you may not be eligible for disability benefits should the need arise.
• Dividends may affect the availability of other deductions that rely on having earned income (e.g. child care expense deductions).
• RRSP contribution room is not generated by investment income such as dividends. RRSPs can provide significant tax sheltering, particularly for the fixed income portion of your portfolio.
• Money invested inside the corporation is exposed to creditors. Options may exist to help address this issue, but they require proper planning.
Salary or dividends? Corporate investment or RRSP contributions? Which is right for you? Itâ€™s a complicated decision that may need to be revisited as your company becomes more profitable.
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