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Financial Planning for Millennials -Podcast

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Hi all, I just wanted to let you know that my first podcast is now available  on itunes for your listening pleasure (I hope). As many of you know, I am a contributing editor to Canadian Moneysaver Magazine and am a huge proponent of financial literacy for reasons too numerous to iterate in one short paragraph. I was interviewed by the Magazine on the subject of financial planning for Millennials for about 45 minutes. Anyway, the link is attached below – happy listening and do be sure to pass this along to anyone else that you think might be interested.

https://itunes.apple.com/ca/podcast/the-moneysaver-podcast/id1362731420?mt=2#episodeGuid=8d37845b03ce4078af17b26efb50b13b

Corporate Investment Income: Navigating the Rules of the Tax Game

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Introduction

If you’ve made it through my first two articles, you’ve hopefully learned a few important things about how Canadian-Controlled Private Companies (“CCPCs”) are taxed. My first article talks about how profits from an active business are taxed inside your operating company, whether you take it salary, dividends or keep it in your company for a rainy day, showing how unincorporated and corporate business owners pay a similar amount of tax if withdrawing each year’s profits as they go in their own names.  It also explains, on the other hand, why business owners who incorporate can still be far better off than their sole proprietor pals if they have excess earnings that they can spend inside their business to grow their earnings or to invest in the stock market.

My second effort began the discussion regarding how this extra dough you’ve set aside for the future gets taxed when it’s invested in the stock market rather than spent growing your active business. Key points include the fact that you pay a lot more tax corporately on investment dollars than you do when your CCPC turns a profit selling widgets, that a bunch of this tax is refundable, and that your company can pay you both eligible and small business dividends from both investment and business income.

Today’s offering attempts to talk about each of the three main types of investment income you might earn corporately and how they get taxed first in your company’s hands and then in yours when making withdrawals from the corporate coffers. I then try to tie these together so you can ultimately get an idea of how much money you’d actually get to keep for groceries or to fund luxury vacations after you and your company have both paid their share of the tax bill. Not only is this vital for budgeting and tax planning – knowing how much of each type of investment income stays in your own hands net of taxes can help guide your investment decisions as well. When looking at investments, I’m far less interested in my raw rate of return than how much I get to keep after I’ve made the tax man happy!

To apply the information in this article to your own situation, you’ll need to use the corporate and personal tax rates for your province of choice. Here are a couple links to get you started. The examples I use in this article use British Columbia rates as of July 2018:

Eligible Dividends

When your company owns investments that pay out eligible dividends from publicly-traded Canadian companies, which I’ll call “portfolio dividends” to distinguish them from the eligible capital and small business / ineligible dividends that your company pays out to you, things look pretty bad at first glance – there are potentially three levels of tax paid on the same dividend dollar that might leave you wondering at first glance why you didn’t just pay it all to the government in the first place. When the dust settles, however, things work out pretty well – ultimately, if your company passes along all the portfolio dividends it receives each year, its’ shareholders will be left with as about as much post-tax dollars as they’d have if they’d earned these portfolio dividends directly. In fact, families that can still income-split corporate money under the new rules, might be substantially better off than an family where the money is taxed in the hands of single investor!

First the bad news. Assume your CCPC owns shares in RBC and gets a cheque for $73 in eligible dividends. In order to write this cheque, RBC would have had to earn about $100 before tax at 27% to be left with $73 to pay out to your company. Your CPP then pays 38.33% on this $73. And, if you’re in the highest personal tax bracket, you may need to pay another 34.2% or more on the eligible dividend your company passes along to you! At first blush, some of you doing some quick math might gasp in horror when you realize that these rates total about 99.5%!

Now for the silver lining, and it is a big one and has many parts – the 38.33% tax charged in the company is totally refundable if the company pays out as many eligible dividends to shareholders as it receives in portfolio dividends. Put differently, this 38.33% tax charged to your company is more like an interest-free loan to the government that is designed to encourage you to pay out portfolio dividends when you earn them rather than reinvesting them corporately. Although you can still keep the money in the company if you want (and might, such as if you think might be able to pay them out in later years when you expect to be in a substantially lower tax bracket) your company will be out of pocket the 38.33% tax the meantime and won’t earn any interest on it. Any of this refundable tax still owing to your company is tracked by your accountant in a notional account known as the Eligible Refundable Dividend Tax on Hand or “ERDTOH”. At the same time, your accountant will also track how many eligible dividends your company can pay out in the future to recapture these tax dollars.

Just as importantly, the 34.2% rate you might have to pay personally is charged against only the $73 you actually received rather than the $100 actually received by RBC in the first place. Thus, think of it as a 24.966% tax on the original $100, which sounds a lot better than 34.2% tax on what you actually receive.  Finally, I’ve picked a taxpayer in the highest tax bracket, which is a bit north of $200,000 in taxable income per year in B.C. For people in lower tax brackets, the rates are far less. In fact, someone in B.C.  in the lowest tax bracket ($39,676 or less) would actually get a tax refundof $4.99 on that $73 dividend. For these taxpayers, they would get to keep almost 78% of the original $100 earned by RBC after pocketing their tax refund!

For those of you wondering about why these low-income taxpayers are getting a refund, I suggest reviewing my earlier article discussing how business income is taxed, as the same principals apply. Ultimately, any shareholder getting $73 in eligible dividends from the company will be taxed on $100 (i.e. the actual amount received of $73 is “grossed up” by 38% more than it really receives so the taxpayer is taxed on the original $100 received by RBC). They then get a tax credit for a good portion of the $27 tax already paid on that money by RBC, which is more than low income earners would have paid if they’d earned $100 in business income directly, thus entitling them to a refund.

To make life slightly simpler for the rest of the article, I’ll just use the effective tax rate on the actual amounts of dividends received rather than going through the more detailed calculation. In other words, I will use a short-form method of calculating the tax bill that just focuses on the tax rate charged against the actual dividend you receive rather than going through the “gross up” calculations, calculating the tax bill at that marginal tax rate as income and then applying the dividend tax credit. Again, read my earlier article if you’re a glutton for punishment and want to do things the hard way.

Finally, although my example assumes RBC originally earned $100 and a $73 portfolio dividend payment, my calculations below will assume that your company receives $100 which would have required RBC to earn about $136.98 before taxes to generate that larger payout. I needed to use the $73 dividend example to show you how our tax system works. Now, I need to use a $100 dividend example to provide a fair comparison to how much of that you’d get to keep when earning $100 in portfolio dividends compared to $100 in interest or capital gains.

Summary: If your CCPC earns $100 in portfolio dividends, it will be taxed on this amount at 38.33% for a corporate tax bill of $38.33 unless it pays out $100 in taxable dividends that year. The entire $38.33 is credited to the ERDTOH Account and is recouped when your company pays out $100 in taxable dividends ($38.33 x 2.61).

For someone in B.C. making $100,000, their tax bill on $100 in eligible dividends is $18.31 based on a 18.31% tax rate on the actual eligible dividends received. Thus, after receiving their tax refund in recognition to the tax already paid on the $100 by RBC, the tax payer pockets $80.85 (or slightly less because I did some rounding on the corporate calculations) after his personal and company tax bill.

Comparison: If the shareholder instead received $100 in eligible dividends directly from RBC while earning $100,000, he would get to keep $80.85, which is about the same, ignoring rounding, as if the portfolio dividend had been earned by the company instead and paid out to him as an eligible dividend.

Interest

The tax for interest income inside a CCPC is calculated in a different way than for portfolio dividends, although there are several similarities. The tax rate is a disconcerting 50.67% but, like for portfolio dividends, a good portion of this tax is refunded when it pays out small business / ineligible dividends to shareholders. Note: until next year, you can also get back the refundable portion of your interest dollars even when paying out more tax-friendly eligible dividends generated from business income taxed at 27%.

Going forward, the refundable portion of the tax paid on interest, rental income and the taxable portion of capital gains, etc. will be tracked by your accountant and your friends at the CRA in another notional account called the Ineligible Refundable Dividend Tax on Hand or “NRDTOH” Account. For now, both this account and the ERDTOH account discussed previously are combined to form a single RDTOH account.

To recapture the refundable tax paid to the government, your company will need to pay out 2.61 times the amount of tax owing to it in ineligible dividends. Put another way, it gets back $1 in the money owing to it for every $2.61 it pays out in ineligible dividends. Unfortunately, while people receiving the ineligible dividends do get a tax credit they can use to reduce their personal tax bill owing on this money, it is not nearly as attractive as the tax credit earned on eligible dividends.

Perhaps more unpleasantly,  there is another big difference between how portfolio dividends and interest income etc. get taxed inside your company. While you can get back all of the 38.33% tax paid on portfolio dividends, your CCPC will probably be out about 20% of its interest earnings even after recouping the refundable portion. Thus, of the $50.67 tax bill otherwise owing by your company on each $100 in interest, only $30.67 is refundable.

Summary: If your CCPC earns $100 in interest income next year, it will be initially left with $49.33 after taxes, unless it pays out lots of ineligible dividends to its shareholders. Of the $50.67 paid in taxes, $30.67 is refundable and is credited to the NRDTOH Account. If the company pays out about $80in eligible dividends ($30.67 x 2.61), it gets back the entire $30.67 in refundable tax, but has still paid about $20 in taxes.

If the shareholder was earning $100,000 in total income, the $80 he receives in ineligible dividends is taxed at 30.38% for a tax bill of $24.30, leaving the taxpayer with $55.70 or slightly less after rounding.

Comparison: If this shareholder had instead earned $100 in interest income personally, he would pay 38.29% tax leaving behind $61.71 in after-tax profits or about $6 more than when earned through the company.

Capital Gains

Just like if earned personally, only 50% of the total gain is taxed inside your company. The other 50% is tax-free and also gets paid out tax-free to shareholders through yet another notional government account called the “Capital Dividend Account” or “CDA”. For example, if you made a $10,000 gain, $5,000 would be credited to the CDA and could be paid out as a tax-free capital dividend while the other $5,000 would be taxed in the CCPC like interest income as a “taxable capital gain”.

On the other hand, if you’d also had a $2,000 capital loss that year, this would be offset against your gain, in the same way as if you’d earned the gain and loss in your open account. As a result, although your company would only have to pay tax on $4,000 after deducting $1,000 in taxable losses from the taxable $5,000 capital gain, it would also only get a $4,000 credit in its capital dividend account since the $1,000 in non-taxable losses are also deducted from the $5,000 in non-taxable gains.

Finally, if your company has a balance in its CDA that it carries forward that can be used to pay out tax-free loot in future years, be careful about declaring capital losses in future years until you’ve paid out this entire tax-free balance. Any losses realized in later years can ultimately eliminate this credit.

In terms of calculating the tax bill on the net taxable capital gain, that portion is taxed at $50.67 per $100 in B.C., of which $30.67 is refundable and is credited to the NRDTOH (as of next year), while the other $20 is gone but not forgotten. If the company pays out 2.61 times more in ineligible dividends as its outstanding NRDTOH balance, then it would get back the full $30.67 / $100 it paid on the taxable gain, just like for interest income.

Summary: If your CCPC earns $100 in capital gains, net of its capital losses, $50 is tax-free and gets paid out tax-free to shareholders. The other $50 is taxed at 50.67%, resulting in a potential tax bill of $25.34, unless it pays out enough ineligible dividends. $12.67 is credited to the NRDTOH Account. If the CCPC pays out $40 ($12.67 x 2.61) in ineligible dividends, the company is only out of pocket $10 in taxes. Ultimately, it would pay out $90 in dividends, $50 tax-free capital dividends and $40 in ineligible divdiends.

If the shareholder receiving the dividends was otherwise earning $100,000 in taxable income, she would receive $50 in capital dividends tax-free while the other $40 in ineligible dividends would be taxed at 30.38%, or $12.15. She would ultimately keep $77.85 of the $100 originally received by her company.

Comparison: If the shareholder instead earned a $100 capital gain directly instead she would get $50 tax-free, with the other $50 taxed at 38.29% leaving behind $80.86 in after-tax money. This would leave her with about $3 more in her back pocket than if the gain had been earned corporately and then paid out as a combination of capital and ineligible dividends.

Return of Capital

Just like if earned in your non-registered portfolio, some investments pay out tax-free money to your company. Perhaps the two most common types are Corporate Class Mutual Funds or Real Estate Investment Trusts. Most payments from these investments are considered to be a return of your original capital or “ROC”.  Accordingly, since this money has already been taxed, the government doesn’t tax it again. This can be particularly valuable starting next year when active businesses earning more than $50,000 in investment income will be at risk of having to pay higher tax rates on business income since ROC income won’t be included as part of this calculation.

On the other hand, as the expression goes, there is no free lunch – although there is no immediate tax bill when you receive ROC, you will have to pay the piper when you sell your investments. When calculating your capital gain at that time, all your cumulative ROC payments are deducted from your original purchase price, which means paying a bigger capital gain tax bill. For example, if you own a REIT that cost you $10,000 and has paid you $2,000 of ROC before you sell it for $13,000, the $2,000 in ROC will be deducted from the $10,000 initial investment so that your capital gain will be calculated as $13,000 minus $8,000 or $5,000.

Likewise, if you own a rental property in your holdco or opco, you might be able to avoid pay tax on some of your rental earnings (and thus have extra tax-free money sitting in your company) by claiming depreciation of the building as a business expense even though you’re not actually paying this cost each year. When you sell your property down the road, you will have to settle up with the CRA if you’ve depreciated the building more than you get for it at the time of sale. For example, if you bought a property for $600,000, perhaps you spent $500,000 for the land and $100,000 for the building. If you’d depreciated the building down to $70,000 at sale but it was worth $120,000 at that time, you would have to pay back the $30,000 in depreciation (which would be fully taxed, rather than treated like a capital gain), as well as paying tax on the $20,000 increase in value from what you originally spent on the building.

Despite this eventual day of reckoning, investments that pay tax-free cash to your company allow your money to compound faster than money that is either taxed yearly at high corporate rates or forces you to pay it out in order to trigger a corporate tax refund when you’re in a high tax bracket. Quite simply, you’re left with more money to grow. As an added bonus, since you control when you trigger your capital gain bill, you can do so at a tax savvy time, such as when you’re in a low tax bracket or are once more allowed to income-split the money with a spouse under the new income-splitting rules. In other words, not only are capital gains far more tax efficient than interest and also better for taxpayers in higher tax brackets than taxable dividends, they provide extra savings by allowing you to trigger taxes during years when your tax bill might be lower.

On the other hand, return of capital may not be the best thing for you if you’re not planning on reinvesting the money inside the company.  Although the company gets the money tax-free and can pay out the full amount it receives, it will usually have to pay it out to its’ shareholders as a ineligible dividend unless it still has capital or eligible dividends that it hasn’t paid out or it still owes loans to shareholders. The tax bill will still be a lot less than for interest income, but it will be bigger than if you were earning eligible dividends and, in many cases, capital gains.

By way of explanation, this is because ROC payments are treated like the original after-tax business profits you were able to squirrel away in the first place for a rainy day. This was money that you were going to be taxed on upon withdrawal anyway since you were taxed on it at low business rate in the first place on the understanding that you’d to pay more tax on it personally upon withdrawal. Thus, this money isn’t taxed like income or capital gains, but as a withdrawal of your original business earnings and are taxed accordingly.

Along the same lines, you will face a similar situation most of the time when withdrawing other tax-paid money from your company. For example, when the $10,000 you might invest in a GIC is returned to you upon maturity and want to pay the money out to yourself as a dividend rather than reinvesting it corporately, your company would likewise get the money tax free but you’d likely be stuck paying tax personally on the $10,000 as an ineligible dividend.

Summary: If your CCPC earned $100 in ROC payments, it would keep the full amount. If reinvested, this provides a great opportunity for growing a bigger nest egg for the future. On the other hand, the $100 in ROC payments would eventually produce a $100 capital gain for the company in most cases, although this may be many years in the future. I’ve already shown how such a capital gain would be taxed earlier in this article.

If the shareholder received $100 in non-eligible dividends, he would pay $30.38 in personal taxes on the money, leaving him with $69.62 of the original $100.00 received by the company. At least he is receiving the full $100 as a dividend, unlike a dividend paid from $100 originally taxed as interest or a capital gain in your company, since no tax was deducted at the corporate level.

Comparison: If the shareholder received $100 of ROC personally, he would be left with the full $100. Like the company, however, he will likely have to pay tax on an extra $100 capital gain when he sells the investment that produced the $100 in ROC. Although it seems highly unfair that this investor pays no tax upfront on the $100 when received personally when he would have to pay 30% tax in this example when first earned by his company, low corporate tax rates allowed the company to squirrel away a lot more money to invest in the first place. The tax bill the shareholder pays now is what he avoided paying in the year that the company earned the money in business profits had the dividend been paid out then rather than invested inside the company. If the shareholder is in a lower rate now, he might actually be saving on that delayed tax bill.

 Conclusion

As you can hopefully see, after we put our calculators down and our headaches start to fade,  other than when receiving ROC, shareholders earning  and paying out their yearly corporate investment income are left in a similar position to where they’d be if they had earned the income personally, albeit perhaps sometimes slightly worse off. Their real advantage over their sole proprietor friends is that they have a lot more money to invest in the first place by investing business profits taxed only at as low as 12% corporately. The catch, and it is a big one, is that this all assumes your company pays out its yearly investment income. If it does not, then the government collects a rather large tax bill and holds that money until you pay out the profits and income in the future. That’s because the government doesn’t want to allow business owners to benefit from deferring the personal tax bill on their investments like they are able to do for business income.

By the same token, just like for people investing in their non-registered accounts, owning eligible-dividend-paying investments inside your company can still provide extremely tax-efficient income when flowed out to shareholders in lower tax brackets, but capital gains can be even more efficient for investors in higher tax brackets.

Unlike investing personally, however, the new tax rules may provide a few new wrinkles for business owners trying to pick corporate-owned investments. Some investors unable to income-split with a spouse until age 65 under the new rules may try to avoid taxable income now in order to take advantage of income-splitting opportunities later. Likewise, the new rules regarding more than $50,000 in passive corporate investment income may cause some investors to minimize high income investments if worried about losing all or some of their small business tax rate. Others with large unrealized capital gains may look at triggering some of the gains before the new rules kick in next year or will need to be careful about when they trigger them in the future when running an active business.

In conclusion, financial planning is often like an elaborate chessboard with bonus pieces and random rule changes that leave you scratching your head. The taxation of private companies is stellar example of this. Although mastering the rules of the game can’t guarantee success, I still like to think it usually leaves you a couple moves in front of the competition.

 

 

 

Your Company – A User’s Guide Part 2 How Investment Income is Taxed

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Introduction 

If you own your own Canadian Controlled Private Company (CCPC) (i.e. your own small incorporated business or holding company), you’re probably still trying to digest all the new tax changes enacted this January or penciled to come your way in January of 2019. The last change (for now, at least) occurred in the most recent Federal Budget this March and focuses on how passive income will be taxed in your CCPC going forward. While I will address the key changes from this March partially in this and mostly in other articles, the real problem is that many of us have no idea how this income was taxed in the first place. According, this makes it difficult to plan and strategize so you can make money work for you as efficiently as possible or to understand how the new rules might (or might not) affect you.

Due to all of this confusion, I want to go back to the basics and attempt to demystify the confusing blend of acronyms, rules and calculations that are small business taxation. In my last article, I tried to explain how active business income is taxed in your company and how the dividends it pays you are taxed personally. I even threw in some comments about something called “integration theory” (no, it still has nothing to do with the civil rights movement) and the government’s general goal of trying to put someone earning money from a corporation, whether they pay themselves with salary or with dividends, in the same position as a businessperson who decided not to incorporate but who earned the same amount.

In the hopes that my earlier effort has pushed ajar the doorway to enlightenment, today’s effort will try to turn this toehold into something far more substantial so that when your accountant throws a few acronyms your way, you can send a few back in his or her general direction and then say something witty about integration theory. There is no way I can say all that needs to be said in one article, so stay tuned for articles that will hopefully fill in the cracks one piece at a time until you hopefully know so much that you feel like an amateur accountant without the pocket protector.

Like last time, all tax rates and thresholds in this article will be based on British Columbia law. The numbers will differ from province to province, but the general principles remain the same whether you live in St John’s, Newfoundland or Fort St. John, British Columbia.

The Taxation of Passive vs. Active Income – Why Different Rules for Different Types of Income?

Unfortunately, there are a lot of different rules and rates for passive income compared to active business income. This makes sense because the government has a different game plan in mind for how they tax investment dollars earned inside a company. While the government is keen to give a break to entrepreneurs looking to reinvest money back into their business by keeping tax rates on business earnings low so there is more cash left to buy that new widget maker, they don’t want to reward you for instead investing leftover corporate profits into things like stocks and bonds. Although there will still be a lot more to reinvest in the stock market inside a CCPC that was only taxed at 12% than for a sole proprietor who may be taxed at as much as 49.7% (and even higher in provinces like Ontario where we’re looking at potentially 53.53% – gulp!), they want to try to level the playing field by making shareholders in a CCPC either pay tax on their investment earnings at a really high rate corporately (50.67% on interest in B.C., for example) or essentially forcing them to pay the money out of the CCPC as mostly as dividends, so the owners are taxed on them personally at their marginal tax rates. Either way, it’s about the government getting more tax dollars sooner.

The most recent budget takes this philosophy of limiting your ability to stockpile unused business profits in corporate investments rather than paying it as you earn it one step further by penalizing CCPS who earn too much investment income starting in 2019. If your various CCPCs earn more than a combined $50,000 in passive income (i.e. income from things like the total of net rental income from most investment properties, investment interest, investment dividends and the taxable 50% of capital gains from non-business assets) in a single tax year, less of your active business income qualifies for the 12% small business rate. Every dollar over this threshold will reduce the amount of income that can be taxed at 12% by five dollars.

Thus, instead of getting the first $500,000 of active business income taxed at 12%, someone with more than $150,000 in passive income will have all of their active business income for that year taxed at 27%. As you can see from the chart in my last article, the business owner will get most of the extra tax paid up front back by paying less on the eligible dividends s/he receives when this money is paid out of the company that are more tax-friendly than the small business or ineligible dividends they would receive on money that was first taxed at the 12% rate. On the other hand, if the business owner wants to reinvest the money corporately, they won’t have as much to put into stocks and bonds after paying corporate tax at 27% instead of 12%. As a result, the CCPC owner will lose some of the tax deferral advantage s/he has over those of us who haven’t incorporated but have extra profits left to invest in the stock market. They may still be in a better position than their incorporated friends who might have less than 50% of their excess income to salt away for the future, but the gap won’t be as wide going forward.

Dividends Paid from your Company Derived from Investment Income and Business Income

When trying to wrap your head around the difference between how corporate business and investment dollars are taxed, the good new is that three types of dividends generated by your CCPC are the same regardless of how the money was earned in the first place. Thus, it doesn’t matter to the taxpayer if s/he receives their small business, eligible or capital dividends from money originally generated from business activities or from investment dollars, as their dividend dollars will be taxed identically in their hands. The CCPC simply declares what type of dividend it is paying out and the recipient will be taxed accordingly, regardless of whether that dividend originated from business profits or from investment prowess.

The bad news is that there are a lot more moving parts regarding how investments taxed corporately before your CCPC can gets to the point where it can pay you dividends. Even though it won’t make a difference to the shareholder (other than determining the size of the dividend cheque) whether the dividends came from business or investment income, it will make a big difference to the CCPC not only as to whether it was investment vs business income, but also whether the money was originally dividends from Canadian investments, interest or similar types of income, return of capital or capital gains. These different types of income are taxed in different ways and at different rates.

As a result, how the CCPC earns its investment dollars will still have a huge impact on its shareholders, as the more tax paid on the money corporately, the less cash that will be left over to pay its shareholders dividends. Furthermore, the type of investment income earned inside the CCPC will determine what mix of dividend income it can pay out and, ultimately, how much of these dividend dollars the shareholder will be able to keep after taxes, since not all dividends are taxed the same and different types of investments produce different types of dividends.

Building on this last point, as you found out the hard way in my last article, CCPCs can pay out three different types of dividends, each of which produces different tax consequences. I’ll touch on these again in this article for those of you who need a refresher. I’ll provide a basic recap here, focusing on just how these types of dividends can be produced from investments but do remember that business earnings can also generate these types of dividends as well.

With no further ado, the three types of dividends you might receive from your CCPC from its investment portfolio are:

  • “Capital Dividends”, which are tax-free to the recipients. They are generated from the 50% of any capital gains realized inside the company minus realized capital losses. As well, some to all of the death benefits of any life insurance policies earned inside the CCPC generate these tax-free dividends. Your company might own life insurance for business or investment purposes, but this won’t affect how much of the death benefit can be paid out tax-free to shareholders.

 

  • “Eligible Dividends”, which are taxable in your hands, but provide an enhanced dividend tax credit which ultimately means that recipients in the lowest brackets might actually get money back from the government. For example, someone earning $30,000 in British Columbia who receives another $100 in eligible dividends would actually have $106.84 in their back pocket, or an extra $6.84 in bonus loot above the actual amount of the dividend. Those in higher tax brackets, however, might only get to keep as little as $71.32 of their $100 dividend cheque when the dust settles. Eligible dividends paid from a CCPC are taxed in the same way as eligible dividends paid directly to investors who own things like Canadian bank stocks in their non-registered accounts. This makes a lot of sense because eligible dividends paid out by a CCPC from investments come from the eligible dividends it receives from its own investments. In other words, for every dollar in eligible dividends your company receives from its own investments, your CCPC can pay out that same dollar in eligible dividends to its own shareholders, where it will be taxed in the same way as if they’d earned it directly from personally held investments.

 

  • “Ineligible” or “small business dividends.” In a nutshell, any type of investment income generated inside a CCPC that can’t be paid out as a Capital or eligible dividend has to get paid out as an Ineligible or small business dividend (excluding rare circumstances when it gets paid out as a salary or bonus or is used to pay down shareholder loans owing to that shareholder). For example, interest, U.S. dividends, return of capital payments, royalty and rental income, net of expenses would all need to be paid out as ineligible dividends. People getting ineligible dividends do get a tax credit that reduces the amount of tax they would otherwise have to pay on the money personally, but it’s not nearly as generous as an eligible dividend. For example, the same Vancouverite receiving $100 in ineligible dividends who otherwise made $30,000 this year would only get to keep $90.23, while his tennis partner who is in the highest tax bracket would keep only $56.30 after taxes.

Conclusion

Although there is a lot more information to come, this is as good a place to stop for today. If you can now identify each of the three types of dividends you might receive from your CCPC and understand how they are or, in the case of capital dividends, are not taxed in your hands, I will consider myself a happy man. If you’re clear that any of the three types of dividends might be generated by either investment or business income, or a mix of the two, then even better. If you can also talk about why our corporate tax system is designed as it and how earning too many passive investment dollars might impact how your active business income will be taxed as of next year, I will be over the moon.

Next time, I will focus on how different type of investment earnings are taxed corporately so you can better understand how much you will have left to reinvest or pay out. Even more importantly, I’ll talk about how many of those dollars you will get to keep when you receive dividend payments from your company and compare where you’d be after taxes if you invest corporately or personally. My goal is to give you enough information so you can ultimately make an informed choice regarding how to allocate investments among your personal, registered and corporate accounts in order to make your money go as far as possible. As I love to remind clients, it’s not what you make, but what you keep after the tax man has come and gone that really matters.

 

Leave to Grow or Withdraw Some Dough – Factors to Consider When Pondering Early RRSP Withdrawals – Part 3

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In this article, I’ll pick up where I left off at the end of my last article, fleshing out some of the things to keep in mind when deciding what to do with your RRSPs and RRIFs. For those of you coming late to the party who have not read the first two parts of this series, I suggest doing just that. Part 1 does some basic mathematical calculations showing how early RRSP withdrawals can mean big savings later in the right circumstances, while Part 2 starts explaining why. For those of you who have been with me since the beginning, the end is now in sight. Let’s cut to the chase.

  • GIS and Other Benefit Planning.People expecting to have very little taxable income during retirement may end up paying a lot more tax on the RRSP withdrawal by way of lost government benefits and government subsidies. If you expect to earn GIS benefits in future, each $2 in RRSP withdrawals can cost you about $1 in GIS benefits. Likewise, some provinces offer subsidies on drug costs during retirement based on income levels. Perhaps most importantly to some Canadians, the cost of public retirement facilities is based on income levels. Accordingly, reducing your tax hit prior to moving into an assisted living facility may reduce your care costs later. These are just some potential examples.
  • Poor Health or Life Expectancy. One of the biggest factors against withdrawing money early from your RRSP can be the lost profits you would have received on the money that you have to pay now in taxes that would have remained invested inside your RRSP if you do nothing. Although those lost profits will also be eventually taxed, some of them would still find their way into your back pocket. The less time between when you trigger taxes early compared to when you would have had to otherwise pay them anyway, the less time the tax paid early and profits on them would have had to grow inside your RRSP.

For example, if you pull out $50,000 from your RRSP a year earlier than necessary at a 30% average tax rate rather than waiting and paying 50% on the same dollars the next year, although you’d only have $35,000 to work with initially, you’re probably still far ahead of where you’d be if you let it ride for an extra year. Even assuming your investments grew at 20% and were taxed completely as interest at 50% in both cases, I’d much rather settle for getting $3,500 after taxes on the $35,000 I withdrew early (or $37,500 after taxes) than paying 50% tax on $60,000 in my RRSP a year later and keeping only $30,000after the CRA gets its cut. Of course, the benefits of early withdrawal are far more pronounced if the non-registered money is invested more tax efficiently. For example, if the $35,000 went into a TFSA and still made 20%, the early withdrawer would earn $7,000 after tax that year while procrastinator would only make $5,000 after tax despite having $15,000 more before tax to sink into the market.

Ultimately, if you knew when you were going to pass on or that you wanted to use more than just the minimum amount you’d need to take out from your RRIFs in a few years, can get it out at a low tax rate, and can invest it tax-efficiently, it might make sense to bite the bullet.

  • Tax Deductible Investment Fees. If you pay investment fees inside your RRSP or RRIF, you can’t deduct them each year. Although you still pay them from inside your accounts and will get the same thing as a deduction eventually since you won’t have as much money to be taxed on, you need to wait until withdrawal to get this benefit. If, instead, you have a non-registered portfolio and pay a percentage annual or monthly fee to your broker, you can deduct this fee each year. This works particularly well if you are earning dividends, capital gains or return of capital, which are taxed at lower rates than the deduction you receive from paying your fees. Thus, you get to deduct your fees now if in an open account rather than later and get to deduct them against investment income that likely won’t be taxed as heavily as it would if invested inside your RRSP.
  • Potential Estate Unfairness When Using Beneficiary Designations. If naming multiple beneficiaries on an RRSP or RRIF, the survivor gets the whole thing if the other(s) don’t outlive you. This can be a problem if you name your children jointly but would want grandkids to inherit in their parents’ place. To make things even worse, the surviving children would get the money tax-free most of the time and your estate would be the one paying the piper. That would mean that if your grandkids inherited their deceased parents’ share of the rest of the estate that they would get a smaller piece of that pie as well, as their share of the estate would be net of the tax bill on the RRSPs that went to their aunts and uncles. Obviously, you can update your beneficiary designations if necessary if you are still healthy, but if you are not, this cannotusually be done through a Power of Attorney. Thus, if you are sick for many years, you are banking on the fact that nothing happens to any of your children during that time.

An easy solution is leaving the RRSPs etc. to your estate and accepting that this means probate fees and exposure to Will and estate issues. For larger registered plans, consider leaving them to a trust that can stipulate what happens to a deceased child’s share while still avoiding probate fees and estate challenge issues. Unfortunately, many people just rely on the simple beneficiary designations for their registered plans. Accordingly, I wanted to make sure my readers are aware of this problem.

Factors Discouraging Early Withdrawals

Most of the considerations mentioned in this and my first two articles in favour of pulling your RRSP money out early suggest keeping your RRSP intact should the necessary conditions not apply. For example, you might be better off taking some money out now if you are in a lower tax bracket, love dividends, have poor health and don’t expect to draw down your RRSP before death. Conversely, if you are in great health, may use all your RRSPs during your lifetime and love interest-based investments, you might be better off leaving things alone for now.

Here are a few other things to keep in mind that might suggest you keep your RRSPs intact for as long as possible:

  • RRSPs and RRIFs have creditor protection, which might be really useful for those unlucky few facing bankruptcy or a nasty law suit;

 

  • The first $2,000 of RRIF money for those over 65 qualifies for the pension income credit. Accordingly, some of us with smaller RRSPs might be better off (depending on whether they are getting GIC or other income-based benefits) to take their RRIF money out $2,000 at a time. Assuming that it all comes out this way over time, it essentially means you can get your RRIF money out with little tax owing. As well, your money gets to compound for longer as you wait, which can mean more money to you over the long term.

 

  • RRSPs and RRIFs have beneficiary designations, which is an easy way of avoiding probate and potentially estate creditors. You can get this protection within TFSAs, segregated funds or other planning techniques if owned outside of your RRSP or RRIF, but it might also require a bit more effort and work on your part to put this in place;

 

  • If you have a financially dependent, disabled child or grandchild, you may be able to rollover up to $200,000 of your RRSP or RRIF to that person at your death, minus any other contributions made to their plans during their lifetime; and

 

  • It is easier for you to budget when inside your RRSP / RRIF. Some of us, such as those who are spenders or have a hard time saying no when children ask us for money, may benefit from keeping the cash in the RRSP / RRIF as long as possible if it helps with budgeting or makes it a bit harder to write that cheque for a child that is not truly in need;

Conclusion

Don’t get me wrong – I love RRSPs, particularly for clients in high tax brackets now than expect to be in lower tax brackets later. It’s just that I think about them in the same way that I think about investing – it’s all about having an exit strategy. If I can cash in registered money on the cheap, deploy it more tax efficiently afterwards and also increase my financial flexibility, then, why wouldn’t I? Although it probably means looking at a smaller pool of investable assets in the short and also perhaps the medium term, it all comes down to how much is left after taxes and what I can do with the money rather than the size of my account before the tax man has received his due. Finally, life and circumstances are always changing and are rather complex. I like to be financially nimble and to be able to raise cash without worrying about triggering a huge RRSP withdrawal tax bill, unless the costs of withdrawing more of my RRSP money now simply don’t make sense.

Accordingly, rather than relying on principles like it’s always good to defer RRSP withdrawals or to always take the money and run, it really depends on individual circumstances and usually requires revisiting your planning from time to time to see if yesterday’s advice still holds true today. Thus, I must unfortunately return to where I began two long articles ago. If asked whether or not it makes sense to withdraw RRSPs early, my answer still remains: it depends. Now, at least, I hope you know why.