At some point this month—probably when you're sitting down to dinner—the phone will ring and your bank or investment advisor will be on the other end. A friendly voice will urge you to make an RRSP contribution before the March 1 deadline so you can trim your taxes and build savings for retirement. The logic will sound compelling—but, if you have your own firm, you'd best just return to your dinner.
"Most business owners should not be buying RRSPs," says Tim Paziuk, president of TPC Financial Ltd. in Victoria and author of The Financial Navigator. That advice may sound like heresy, and it's not widely followed: 43% of the CEOs in the 2012 ranking of Canada's Fastest-Growing Companies use RRSPs.
But, Paziuk says, these popular plans are much better suited to salaried employees. "Business owners have choices that the general public does not have, but often no one has sat down with them and explained the alternatives."
Salary or dividends?
One of these choices is whether to pay yourself a salary or take money out of your company in the form of dividends. A salary allows you to build RRSP contribution room; your annual limit is 18% of your earned income, to a maximum of $23,820 in 2013. Dividends, on the other hand, are not considered "earned income," so they won't get you any RRSP room. That's why the conventional wisdom suggests that you, as a business owner, should draw enough in salary each year to max out your RRSP. In 2013, that works out to an annual paycheque of $132,334.
RRSPs can create a huge tax liability for your estate. That might mean losing half of it to the Canada Revenue Agency
But this ignores the bigger picture, says Paziuk. You often are better off taking no salary at all; instead, you should determine your annual spending needs and draw out that amount in dividends. Any surplus should stay in your company (or in a separate holding company), where it can be invested to benefit you in, say, stocks or bonds or in growing the business. Then, when you're ready to stop working, those investments—and not an RRSP—can fund your retirement.
Not all income is created equal.
In a perfect world, the government would collect the same amount of taxes whether you receive a salary or a dividend. If your company pays you $1,000 as salary, you might lose 45% of that to income taxes and keep $550. If it instead pays you a dividend, the company might first fork out 20% in corporate taxes on that $1,000, then pass along the remaining $800 to you. If you were taxed at 31.25%, you would net the same $550. This is what tax experts call the "theory of integration."
In practice, however, that's almost never the case, says Jamie Golombek, managing director of tax and estate planning with CIBC Private Wealth Management in Toronto. "In eight of the 10 provinces, it makes sense to pay out the money you need to fund your lifestyle as a dividend," says Golombek. (The exceptions are P.E.I. and Quebec.)
In Ontario and Nova Scotia, for example, you'll save well over 3% of the total by taking the money as a dividend. One of Paziuk's clients is an Ontario doctor who needs $300,000 to fund his lifestyle. By withdrawing this money from his company in the form of dividends, the doctor will save about $10,000 a year in income taxes. He also avoids more than $4,700 in Canada Pension Plan (CPP) premiums, which are payable only by those earning a salary.
The downside of RRSPs.
Of course, taking no salary could mean you'll reach retirement without a dime in RRSPs. But that can be a benefit for business owners. "You're at the mercy of government policy when it comes time to draw down your RRSP," says Paziuk. For example, you have to start making withdrawals—which are fully taxable— at age 71, whether you need the money or not. "Whereas, if you leave the money in the company, you can draw it down only when you actually need it," he adds.
RRSPs also can create a huge tax liability for your estate. When one spouse dies, for example, his or her RRSP passes to the surviving spouse tax-free. But when the second spouse dies, the combined RRSP becomes taxable in the year of death. That might mean losing half of it to the Canada Revenue Agency. "If you let that money accumulate in your company," explains Paziuk, "the tax rate on death is significantly lower than when it's in an RRSP."
There are potential downsides to building your savings inside your company: you may have fewer opportunities to split pension income with your spouse in retirement, and RRSPs are protected from creditors if your firm goes bankrupt. "There's also the comfort factor of having a separate account outside the business," Golombek says. "There is a sort of imaginary fence around it."
But for most business owners, RRSPs are not the right way to save for retirement. "If you leave the money in your company," says Paziuk, "then you control your own destiny."