“I frequently work with successful business owners who often aren’t maximizing their RRSP and TFSA contribution. Some may be acting on advice from their accountant or may just have the perception that keeping wealth within their corporation or holding company instead of topping-up their RRSP and TFSA will defer personal tax and help their wealth accumulate quicker. While this may be true in some cases, for most it isn’t.”
Jonathan Grant is an Associate Portfolio Manager and Senior Investment Advisor with the Grant Wealth Management Group at TD Wealth Private Investment Advice in Orillia. He often works with business owners who are not maximising their RRSP and TFSA contributions when they should be doing so.
A better option for tax deferral
If you operate a business through a corporation, you have two main options for deferring taxes when investing business profits.
You can leave excess funds in the corporation for investing, or you can withdraw funds and add to your Registered Retirement Savings Plan or Tax-Free Savings Account. Jonathan says, “some business owners believe that keeping wealth within their corporation or holding company rather than topping-up an RRSA or TFSA will accumulate wealth more quickly, but in most cases, this is not the best strategy.”
Let’s take the example of an active business in Ontario that will pay corporate tax on the first $500,000 of active business income at the federal and provincial small business tax rate of 12.2%. Jonathan says, if the after-corporate-tax wealth is retained within the corporation or moved by way of tax-free intercorporate dividend into a holding company, there will effectively be a tax deferral of 41.33%. That’s assuming the individual is in the top tax bracket of 53.53%.
The wealth retained in the active business or holding company and invested in a portfolio will then have the chance to grow at a faster rate than having it taxed in the hands of an individual.
Jonathan says, “if the wealth is invested in a passive investment portfolio within a corporation, the passive income will be taxed at the highest corporate tax rates, which I remind my clients, is still less than the highest tax rate for individuals.”
Maximizing your RRSP tax deferral options
However, if the individual is drawing a salary from their business for their own personal consumption, they are creating RRSP contribution room in their business account.
Jonathan points out, “if they take a slightly higher salary or additional dividends out of the corporation and contribute to their RRSP, they will receive a tax deduction which will lower their taxable income and therefore they won’t have to pay any additional personal income tax income contributions.”
The growth attributed to the tax advantages within the RRSP will accelerate faster than the taxable growth within the corporate portfolio, assuming the corporate portfolio is earning taxable income. Jonathan adds, “at the end of the day, the tax-advantaged growth within an RRSP will provide more after-tax wealth even though withdrawals from an RRSP or RRIF are fully taxable and corporate withdrawals through a combination of taxable dividends and tax-free capital dividends are taxed at lower rates.”
The tax advantages offered in an RRSP give the investor more wealth over time.
Taking advantage of TFSA contributions
In the case of TFSA contributions, there will be some personal tax payable to withdraw the amount needed from the corporation to contribute to the TFSA, as TFSA contributions are not deductible. However, at the end of the day, the long-term tax advantage growth within the TFSA could potentially provide more wealth when compared to a corporate portfolio of investments that has taxable income.
Jonathan points out, “for a corporate portfolio that does not have taxable income, interest income, or dividends, and shares and securities are held wit no capital
gains being triggered over a longer period of time, the corporate portfolio will out-perform both an RRSP and TFSA. However, in most cases, corporate portfolios will have a mix of investments with interest income and dividends. Also, keep in mind there will be buying, selling, and rebalancing that will trigger taxable capital gains.”
Corporate passive investment concerns
Another consideration around the corporate passive investment portfolio is the federal rule for grinding down the small business deduction which applies to the first $500,000 of active business income.
If the corporate portfolio creates more than $50,000 of passive investment income, the $500,000 small business deduction will be ground down by a rate of $5 for every $1 above $50,000. However, Ontario doesn’t follow this federal rule, so an additional 6% can be added to the 12.2% small business rate on the grind of the active business income.
For example, if the corporate portfolio’s passive income is $75,000, then the small business deduction will be reduced by $125,000. The calculation is $75,000 less the $50,000 limit multiplied by 5. If the active business was making full use of the $500,000 small business limit, it would pay an additional 6% on the $125,000. If passive income in a corporate portfolio is $150.000, then the entire $500,000 small business limit would be completely reduced for federal tax purposes, resulting in an additional $30,000 in corporate tax each year on the active business income.
What should a business owner do?
At tax time, a successful business owner needs to ask themselves if they should maximize their RRSP and TFSA contributions or keep their money within a corporate portfolio. Jonathan says, “The answer is, it depends. Very often it does make sense to top-up RRSP and TFSA contributions. But, if a client is aggressive and has 100% in equity buy and hold portfolios, it may be best to keep the wealth within a corporate portfolio avoiding the higher personal income tax on the withdrawal from an RRSP or RRIF.”
However, in most cases, if the corporate investment portfolio creates taxable income, it is best to put the eligible limit in an RRSP or TFSA.
Please ensure to consult your individual tax specialist before implementing any tax strategy.
Jonathan Grant would be happy to discuss how you can maximize your tax deductions. You can reach him at (705) 330-0067 or email: [email protected]
The views expressed are those of Jonathan Grant, Associate Portfolio Manager and Senior Investment Advisor with Grant Wealth Management Group as of February 3, 2023, and are subject to change based on market and other conditions. Grant Wealth Management Group is part of TD Wealth Private Investment Advice, a division of TD Waterhouse Canada Inc. which is a subsidiary of The Toronto-Dominion Bank.