When business owners shouldn’t make RRSP contributions

(Photo: Dinodia/Getty Images)

(Photo: Dinodia/Getty Images)

If you own a corporation, should you contribute to an RRSP?  Most advisers have in the past answered yes to this question. But a growing number now say the opposite. Here’s a summary of this view (relevant documents are listed at the end of this article).

The conventional wisdom has been to pay yourself enough of a salary to maximize RRSP contributions (for 2013, the maximum RRSP deduction is $24,270, which requires $134,800 of salary). Dividends from the business do not qualify as earned income, so cannot be used to make RRSP contributions. But since they are taxed at lower rates than salary income, they should be used to cover living expenses not funded by salary paid out to create RRSP room. If the business owner has a pension or Individual Pension Plan, RRSP contributions need to be reduced by the amount of the Pension Adjustment.

When not to make RRSP contributions

For owners of Canadian-controlled private corporations with less than $500,000 active business income (excludes investment income) the conventional wisdom doesn’t appear to apply anymore in many cases. Reductions in corporate tax rates for such small businesses now make it better to take only dividend income to cover living expenses and to save for retirement by leaving surplus income inside the company to be invested.

In addition to optimizing lifetime after-tax income, saving for retirement within your corporation offers more control over withdrawals from retirement savings. At 71 years of age, RRSP holders have to roll over the plan into a RRIF and take withdrawals according to a prescribed schedule. But if the retirement fund is built up inside a corporation, the owner can sell investment assets as needed and take dividends from the company at a level and rate of his or her choosing.

Furthermore, the businessperson taking only dividend income does not have to pay premiums to the Canada Pension Plan. As the self-employed need to also contribute the employer’s share of the premiums, the payments can take quite a bite. Many business owners believe the money can be better invested inside their company.

There are some caveats to consider. If too much investment income is earned inside the company, the $750,000 capital-gains exemption may be lost when the owner sells her company. But this is not a serious restriction as it can be avoided by extracting investment assets in a number of ways, ranging from paying a retirement allowance to distributing tax-free dividends to a holding company.

Another caveat is that dividend remuneration may not be appropriate for the owner of a company that can be sold for a substantial sum—for example, a manufacturing company or one otherwise possessing substantial tangible assets. Taking only dividend income works best for professionals whose main asset is their intellect and personal labour.

Mark Goodfield, a managing partner of Cunningham LLP in Toronto, offers other considerations for owners thinking about foregoing an RRSP.

  • The gross-up on dividends could result in a partial clawback of old age security income
  • An RRSP is creditor proof (except for contributions made 12 months prior to a bankruptcy)
  • Investment Tax Credits may be reduced under an all-dividend compensation strategy
  • Claiming tax refunds for child care costs requires the lower income spouse to have a salary

The above overview was offered for information purposes. To be sure of optimizing your financial situation, consult with an adviser. Cookie-cutter solutions don’t work well when there is a great deal of variation across people, as is the case with business owners.

Selected sources:

Jamie Golombek, Rethinking RRSPs for Business Owners

Mark Goodfield, Salary or Dividends? Issues to Consider 

John Mill, Rethinking RRSPs – retained earnings/dividend strategy