The good news is over 1 million, or 12% of Canadian working women, are self-employed. This can mean more independence and financial rewards for our labour but it also makes creating a retirement savings plan more complex. That’s because, in addition to considering sources of retirement income, you also need to think about tax considerations and succession planning for your business.
What’s the best way for a small business owner to save for retirement in a
I consulted with Silvia Jacinto, a partner in the taxation group at Toronto-based Crowe Soberman.
Your business funds your retirement
There are tax advantages for Canadian controlled private corporations. The first $500,000 in profits from active business earnings is taxed at a preferential rate of 13.5%. (In comparison, a sole proprietor in Ontario will pay 53.5% in taxes, the highest marginal tax rate, on income over $220,000.)
If you do not need to pull all your profits out of the business, you can invest these after-tax profits in a portfolio of assets to fund your retirement.
How do you get access to this money when you retire?
- Sell the business and these assets will be part of the business valuation.
- Wind down the business and keep the corporation.
If you are a sole proprietor of a small business that provides professional services, you can choose to wind down the daily operations but keep the assets within the corporation. You would still be a shareholder of the corporation and can draw dividend income at a time when your tax burden would be lower.
- Estate freeze
If you plan to pass the business to the next generation, you may want to consider an estate freeze. In this case, you freeze the value of the shares to the founding shareholders. Preferred shares are then issued which can be redeemed over time, triggering dividend income. Further growth in the value of the company will accrue to your successors. Upon death, your estate will pay little tax, as your shares will have wasted away.
Until recently, “income splitting” or “income sprinkling” was a way for higher-income small business owners or incorporated professionals to redirect their income to other, lower-taxed family members, generally through the payment of private company dividends. In December 2017, the federal government released new rules to prevent income splitting using private corporations. Under the new rules, if you are over 18 years of age and receive income from the corporation, you need to be actively engaged in the business or the income will be subject to tax at the highest personal marginal tax rates, eliminating any advantage achieved from income splitting.
Draw a Salary from the Business
You can be an employee of your corporation. If you draw a salary from your business, you are eligible to contribute to a RRSP. According to Jacinto, many small business owners choose to draw the minimum salary required to maximize RRSP contribution room in any given year. As an employee, you will also contribute to CPP and EI, making you eligible to collect CPP on retirement and EI if you elect to take a maternity leave.
You can minimize your income to pay less tax by drawing dividends instead of salary income. This will eliminate your ability to contribute a RRSP.
Mix of Salary and Dividend Income
Enjoy the tax benefits of both by drawing the minimum necessary salary to maximize your RRSP contribution and minimize further taxes by drawing divided income.
IPP – Individual Pension Plan
Your corporation has the option of setting up an IPP, an employer funded pension plan. Employer contributions are tax-deductible for corporate tax purposes and are not taxable to the employee until she starts to generate pension income. To be eligible for an IPP you need to receive employment income. An IPP has higher contribution limits than an RRSP. The corporation can also make a lump sum “catch-up” contribution for past service years. The downside is that compliance costs are high and that IPPs are not liquid.
What’s the best tax-efficient retirement strategy for you?
We’ve outlined various options and our list is by no means exhaustive. It is certainly a good start to understanding some of the strategies available. Tax law is complex and ever-changing, so find a good accountant and financial planner is recommended.