Financial Facts & Money Matters: The End of RRSPs?
Beyond Numbers · October 2005
By John Nicola, CHFC, CFP, CLU; David Sung, CFP, CLU; and Brian Sung, CA, MBA, CFP
Editor: A case study relating to the following article is available on the authors' website at www.nicola-financial.com/analysis.
New financial tax metrics
Did you know that a significant percentage of “high-income earners” ($150,000 - $400,000) would achieve better financial results by saving their money in their corporations than by continuing to make RRSP/IPP contributions? This is true for a lot of incorporated professionals and owner/managers.
Recently, corporate taxes have been dropping. It was only a few years ago that the “low” tax-rate for active business income was 22.6% on the first $200,000 of income, and more than 40% after that. Many incorporated professionals and business owners put all earnings in excess of $200,000 into bonuses and paid tax personally.
However, things have changed since then. To begin with, the “low” corporate tax-rate is now 17.6% in BC and applies to the first $300,000 of income. The next $100,000 is now taxed at 26%, so the average corporate tax-rate on the first $400,000 is 20%. Above $400,000, the tax-rate is about 35.2%, which is still less than the maximum personal tax-rate of 43.7%. In addition, salaries paid to spouses who are not actively involved in the business are being scrutinized more critically by the CRA, which can restrict some of the benefits of income splitting with spouses who earn less income.
After-tax income is the key
The object of saving money is not simply to increase one's net worth. In fact, for most of us the major objective of saving should be to create an investment portfolio that can provide us with the after-tax income to allow us to be financially independent.
For many incorporated professionals and owner/managers, the safest and most efficient way to accomplish this goal is as follows:
- If total pre-tax income after expenses is less than $400,000 annually, the owner and their spouse should take their personal income as dividends and try to split these dividends as equally as possible. Doing so will decrease their total tax bill on personal income when compared to reasonable salary levels.
- Taking income as dividends will mean that you will not have earned income for the purpose of making future RRSP or IPP contributions—this is actually a good thing. If your total income is under $300,000, the maximum tax savings you could generate from making an RRSP/IPP contribution is, in most cases, 17.6%. This is because you could have saved for retirement in your company versus a registered plan by leaving your savings in the company and paying tax at the corporate rate (17.6%). Since your marginal tax-rate at retirement is almost certainly going to be higher than 17.6%, you will pay more tax when you withdraw RRSP/IPP funds as income during retirement than the amount of tax you saved at the time of your original contribution. However, for most high-income salaried individuals, this is not the case, since their current marginal tax-rate would likely be in excess of 40% today.
- If you take dividend income only, you will no longer make future CPP contributions. As a self-employed person making more than $41,000, you and your company are paying about $3,763 in 2005 for CPP. If there are two of you, then as a couple you will pay about $7,526 per year. Almost all individuals would be better off saving this cost on their own than continuing to fund their CPP. However, when you stop contributing you will eventually reduce your retirement benefit; this needs to be factored in when comparing the salary-CPP-RRSP/IPP approach with dividends and corporate savings.
- One of the biggest benefits of registered plans is that investment earnings accrue on a tax-deferred basis until withdrawn. When you invest corporately, your earnings are initially taxed at very high rates. There are several strategies to reduce this corporate tax, and with good asset allocation and efficient tax planning, you should be able to get it below 10%. That said, this process is somewhat complicated and requires a very good corporate structure.
This new approach to saving will work for many people to varying degrees. A few specific issues that must be reviewed to determine how effective this approach will be are summarized below:
- Many incorporated doctors receive RRSP/IPP contributions from the British Columbia Medical Association that match their own contributions, and, therefore, need earned income. For them, usually a salary of between $40,000 and $50,000 will be sufficient to get that matching. In addition, they can also use an EPSP (Employee Profit Sharing Plan) to reduce or eliminate CPP premiums.
- For individuals whose taxable income will be above $400,000, the salary-CPP-RRSP/IPP approach makes sense for the professional or owner/manager, but may not make sense for their spouse. Issues such as reasonableness of salary levels and the amount of net corporate income after the first salary has been paid are key factors.
- As mentioned, there are relatively high taxes on corporate savings. However, these taxes can be dramatically reduced by having the corporation that's investing the funds pay dividends to individual shareholders or trust beneficiaries—the tax-rates on this income will drop significantly. And the taxes can be reduced further by keeping interest income in registered plans and UL policies, and dividend rental income after depreciation and capital gains in the corporation; doing so can reduce the average net corporate tax-rates below 10%.
- Passive corporate savings can make the shares of an active business ineligible for the $500,000 tax-free capital gains exemption if they exceed 10% of the assets of the company. With the dividend and corporate savings strategy, that would almost certainly happen. However, there are techniques for purifying companies to get the exemption back and other approaches, such as the use of holding companies. This kind of planning requires the advice of an accountant.
At the present moment, most of us have an opportunity to take advantage of very low tax-rates on active business income. This awareness should change how many of us take our income and save our money.
John Nicola, CHFC, CFP, CLU; David Sung, CFP, CLU; and Brian Sung, CA, MBA, CFP, are principals with the Nicola Financial Group in Vancouver, which specializes in financial advising for professionals and business owners.
Attend the PD seminar on October 13, 2005
The authors will be instructing a seminar entitled “The End of RRSPs and IPPs? How You Can Effectively Reduce Tax on Both Compensation and Investment Income” on October 13, 2005, from 9am – 12:30pm, at the Sutton Place Hotel in Vancouver. Register at www.icabc-pd.com or by phone at 604-488-2641.