As a self-employed business owner, you need to plan your own retirement. When the time comes to take accumulated profits out of your company, should you pay yourself dividends, contribute to your registered retirement savings plan, or both? Find out what you need to consider so you can make an informed decision.
Tax Advantages of RRSPs
In the Canadian tax system, RRSPs are the premium retirement savings mechanism. Contributing to your RRSP lets you defer taxation on your current income until you retire, allowing you to earn investment income on your contributions tax-free. Since you are likely to pay taxes at a lower rate when you are retired than you do now, the tax deferral can actually be a tax savings.
If you are a small business owner, however, there is a catch. RRSP contributions are subject to a limit equal to 18% of your employment income up to a maximum of $26,010 (for 2017). To contribute the maximum amount to your RRSP, you need to pay yourself a salary of close to $145,000. The RRSP deduction will lower your taxable income to approximately $120,000, but at that level of income, your marginal tax rate will still be somewhere around 50%, depending on your province of residence.
Contrast this with the payment of dividends. Dividends are not eligible income to create RRSP contribution room, so you will not benefit from a deduction. However, the marginal tax rate that you pay on dividends, depending on your province of residence, will be somewhere between 30% and 40%. If you reinvest the funds from your dividends, they may be taxable, unless you use another deferral mechanism such as a tax-free savings account.
The real question is whether it is worthwhile to pay slightly more taxes now to benefit from a tax deferral on investment income. The answer is different for everyone, but a mix of dividends and salary is almost always the answer. When deciding, take the following elements into consideration:
- What is your province of residence, and what are the actual rates that apply to you?
- Do you have unused RRSP contribution room? Do you need to create more?
- How much time do you have before you retire?
If you have unused RRSP contribution room, then you are more likely to favor dividends – at least in the short term – to benefit from lower tax rates while still being able to make RRSP contributions. If you are younger, RRSP contributions become more advantageous, because they can grow tax-free for a longer period of time.
There are many variables in play, and there is no single answer that is applicable for every self-employed business owner. You should carefully analyze your specific circumstances, and consider consulting a tax advisor to determine your best course of action.