Jared Burns, CPA, CA
February 5, 2022
Business owners have a lot of tough decisions to make. Deciding where and how to invest for retirement can be a challenge.
My boys love the “Who would win” books by Jerry Pallotta, especially the “Ultimate Ocean Rumble”. In the book, sixteen creatures agree to participate in a bracketed battle. For this article instead of determining who would win between a sand tiger shark and a saltwater crocodile, we will look at who would win between drawing additional salary from your business to contribute to your Registered Retirement Savings Plan (RRSP) versus leaving the money to corporately invest.
This is an ancient battle that is looked at often if you operate your business through a corporation. But rates change year to year and reminders are always helpful as we are in RRSP season. To keep the battle fair we need to first give a few reminders and set out some assumptions.
We are assuming you draw a salary to pay yourself for your personal living expenses and that you do not take only dividends. Salary creates RRSP room, dividends do not. We will also assume your tax rates remain the same from time of investment throughout retirement for both scenarios. RRSP contribution limit is 18% of the previous year’s salary up to a maximum of $27,830 for 2021 ($29,210 for 2022) and any unused contribution room created from prior years carry forward.
We will be using a balanced portfolio with a mix of 60% equity and 40% fixed income. The balanced portfolio will have an annualized rate of return of 5% per year. The breakdown of what makes up the 5% return will follow what we typically see in our balanced portfolios. The 5% is broken down as follows: 2% interest income, 0.5% dividend income, 1 % realized capital gains and the last 1.5% is unrealized capital gains. Remember different income sources like interest are taxed higher than other sources of investment revenue like dividends and capital gains. Also remember unrealized capital gains are when stocks increase in price above what you paid for it, but you haven’t sold it yet hence no tax until liquidation.
An example to illustrate. You have a business called Plexiglass Inc. (PlexiCo) which is a manufacturing business. Business has gone from steady to very busy during the pandemic as businesses seek your product to better protect their employees. It’s now RRSP season and you were able to earn your usual gross salary of $125,000 for your family’s personal expenses, plus this year for the first time you have some excess profits that neither you nor the business needs for reinvestment. The amount available is $25,000.
You have two very appealing choices to consider for investing your excess profits. Take the $25,000 and pull it from your corporation and invest it in your RRSP and then draw it out in retirement as regular income. The other is to keep that money at the corporate level and invest it and then eventually during retirement draw out the funds using a dividend.
The first choice will leave you with the full $25,000 to invest in the RRSP. At a growth rate of 5% over 25 years gives you $88,892 in your RRSP account. Applying the beginning 2021 bracketed tax rate of about 43% on ordinary income leaves you with $51,095 in after tax funds in your jeans pocket.
The second choice gives you $22,125 to invest corporately because of the reduced salary expense that you cannot corporately deduct at the small business rate of 11.5% like in the first scenario. After 25 years at a growth rate of 5% in investment revenue, broken out and taxed in the percentages outlined above will leave you with $50,398 in your corporation. Applying the 2021 dividend tax rate and refund mechanism, as well as the capital dividend account at the same bracketed tax rate on dividends when the investment was made leaves you with $40,895 in your pocket. About 10,000 less than the first choice of RRSP.
In this example we see that drawing excess profits from your corporation and putting them in your RRSP will outperform corporately investing in a 25-year timeline. Every case should be evaluated to consider your specific circumstances but if you are investing for the long haul, consider using your RRSP.
Author:
Jared Burns CPA, CA is the Director of Estate and Tax Planning with Louisbourg Investments. Submit your comments to jared.burns@louisbourg.net.
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This writing is for general information purposes only. It is not intended to provide legal, accounting, tax or financial advice. For complex matter you should always seek help from a professional. Any opinions expressed are my own and may not reflect those of Louisbourg Investments.
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