Most incorporated business owners understand why they’d want to keep excess earnings in their corporation, which is to defer paying personal income tax. The tax rate on active business income is 12.2%, which is lower than that on personal income (53.53%) at the highest marginal rate.
While this strategy does make sense, it’s worth noting that Canadians with excess funds in a corporation would generally be better off paying out some retained earnings to invest in a Tax-Free Savings Account (TFSA).
Here’s why:
There is no tax deferral for interest income, dividends, and realised capital gains earned on passive investments (think stocks, mutual funds, ETFs etc.) in a corporation. Each year you receive Tax slips associated with many of those investments.
In Ontario for example, passive income in a corporation is taxed around 50%. Over the long run, the tax-free growth in a TFSA will likely outperform corporate investments that are subject to annual taxation.
Despite having less to invest after paying the initial personal income tax, there are no tax slips each year on the invested capital and thus, given the same investment, the net or after tax yearly return is higher in the TFSA than inside the corporation. Over a long period this higher net return closes the gap on the higher initial invested capital in a corporation.
Lastly, when money is needed for spending, the TFSA proceeds come out tax free while the investments in the corp are subject to any capital gains tax and then personal income tax when paid out via dividend or salary to the individual shareholder.
There can be some exceptions. Investment returns derived from deferred capital gains and eligible dividends from Canadian corporations may be better off kept in the corporation.
However, most investors have investments with a combination of income types, and secondly, few investors would defer all capital gains indefinitely. Thus, maximizing TFSA contributions is still recommended.
The key advantages of withdrawing funds from the corporation to invest in a TFSA include:
- Tax-free investment growth inside the TFSA
- Tax-free withdrawals from the TFSAIf at some point in the future you have an episodic expense that comes up, like a home renovation or the purchase of a cottage, having funds available in your TFSA, will save you from incurring a massive taxable event drawing funds from your corporation.
- Allows for ongoing or periodic tax free rebalancing or investment changes.
- Provides insulation against possible future tax changes to corporations.
Will This Work For You?
For most business owners the TFSA’s tax-free advantages make it a smart choice vs indefinitely deferring personal taxes by keeping excess funds invested in the corporation.
If this is something you think could work for you, email me back and let’s set up a time to talk.