Should You Invest in Your Tax Free Savings Account?
Should you withdraw from your corporation to make a TFSA investment?
For as long as you have been a business owner you have likely been told that you should use your corporation to save for retirement by investing excess funds. This is true, as you will be able to achieve significant growth in the corporate portfolio due to the deferral of personal tax. With changes to the passive income rules and the benefits of the TFSA, we thought we would take another look at the numbers.
TFSA earnings are tax-free, but the money for investing needs to come from somewhere. If that somewhere is your corporation then you are going to pay personal tax on the withdrawal first, leaving a net amount to invest in your TFSA.
An example:
A successful business owner in Alberta pays corporate tax at 11% and is likely paying personal tax at 40% for other than eligible dividends. The cumulative TFSA maximum contribution is $63,500 for 2019.
The business owner could pay out a dividend of $106,500 from the corporation, which after personal tax is paid would leave $63,500 available to contribute to a TFSA. Alternatively, the $106,500 could be retained in the corporation and invested in a corporately held portfolio.
In ten years’ time, assuming a 5% growth rate in all years, the TFSA will have grown to $108,427.
If the funds are retained in the corporation and invested, the portfolio will have grown faster than the TFSA, but will now need to be paid out to the shareholder in the form of a dividend.
Depending on the type of investments held in the corporate portfolio there will be different corporate and personal taxes paid if the corporation is receiving interest, eligible Canadian dividends or capital gains.
While in the real world a portfolio is likely going to earn all three types of income, for the sake of comparison we have assumed that only one is earned in each scenario.
As you can see, no matter what kind of income is earned by the corporate portfolio the growth has substantially outstripped the TFSA (Line A).
Interest income earned in a corporation has the most unfavourable passive income treatment, resulting in the most corporate tax of all options. This leaves less for the shareholder (Line B).
If instead, the portfolio earns only dividends from blue-chip investments, the corporate tax on the dividend income will be fully refunded upon the payment of the dividend to the shareholder. This essentially transfers the tax to the personal level. Additionally, most dividends from an investment portfolio in a corporation allow for the corporation to pay “eligible” dividends to the shareholder. The personal tax rate for eligible dividends is 32%, rather than 40%. This option would result in $106,389 of cash available after tax.
Finally, if the corporate portfolio has capital gains, only half of the gain is taxed in the corporation. The remaining half can be paid out as a tax-free capital dividend*. This results in both lower corporate and personal taxes and net after-tax cash available of $115,269 (Line B).
*For further information about capital dividends, see this article.
Conclusion
Every corporation, person and portfolio are different. The scenarios above are built on several key assumptions that have resulted in the final amounts received.
The benefit of withdrawing funds from a corporation to invest in a TFSA will greatly vary depending on the type of income that is being earned as well as the amounts contributed per year, and the income source of your spouse.
We would be happy to discuss your individual situation with you and find an optimal solution to maximize your retirement savings. The VR team would be happy to clarify any questions!