The article “How to draw money out of your corporation in retirement” was originally published in MoneySense on November 2, 2021. Photo by Maria Lupan on Unsplash.
When you have money saved in a corporation, retirement planning can be a little more complicated. But it can be done.
Incorporated business owners can sometimes be unsure of how best to decumulate, drawing from their corporate savings along with their other investments and pensions. Corporate savings do provide complexity as well as opportunity.
From paying yourself a salary to drawing income
Business owners typically pay themselves a salary during their working years. A salary is deducted from corporate business income, reducing corporate tax payable on that income. And that salary is then taxed personally. When a business owner retires, they typically have no more business income earned by their corporation. They may have cash or investments in their corporation or they saved with a separate investment holding company that generates investment income.
Retired business owners sometimes continue to pay themselves a salary, though they probably shouldn’t take a paycheque at this point. Salary can be deducted against business income but it may not be reasonable to deduct from a corporation’s investment income. More importantly, paying a salary in retirement may not be tax efficient.
Also, getting paid a salary also generally requires deductions, including Canada Pension Plan (CPP) contributions, which is also matched by the corporation. The total is 5.45% on salary up to $61,600, with a basic exemption on the first $3,500. Paying CPP contributions does potentially increase a retiree’s CPP pension, but not necessarily if they have already reached the maximum entitlement.
Paying for expense through the corporation
Some business owners continue to pay for expenses out of their corporation. These expenses may include a cell phone, car costs, internet or other fees. Some portion of these expenses may have been personal in nature even prior to retirement, but just because you have a corporation that does not mean you can continue to use it to pay certain expenses without any personal implications.
Personal expenses paid by a corporation, even those that may have been legitimate and fully deductible business expenses pre-retirement, may have to be added to your personal income in retirement.
CPP, OAS and business income
You can start using CPP and Old Age Security (OAS) pensions as early as age 60 and 65, respectively. Each can be deferred to age 70, and doing so results in an increase in both pensions.
Some retirees would benefit from deferring these pensions, whether they have a corporation or not, especially those with a long life expectancy, no other defined benefit pension sources, or a conservative risk tolerance.
CPP and OAS deferral may allow a business owner to deplete their corporate assets in their 60s to wind down their corporation, particularly if the cash and investments are modest.
Dividends may be the better option—tax-wise
Cash and investments within a corporation are an accumulation of after-tax business profit. Corporate tax payable by small businesses on business income generally ranges from 9% to 13% currently, depending on the province or territory as well as other factors. A shareholder of a corporation can receive a dividend on their shares instead of a salary.
A dividend is a distribution of after-tax corporate profits. It is taxed at a lower rate personally to reflect the corporate tax already paid when the business income was earned.
Typically, dividends are taxed at about a 10% lower rate than salary, but the rate does range, depending on income and province or territory of residence. So, paying dividends is not only more appropriate for retirees, but also typically less taxing.
To receive dividends, one must be a shareholder of the corporation. If you have a spouse or common-law partner who is not a shareholder of your corporation, you may want to consider adding them as one.
If the corporation is no longer earning business income, you are 65 or older, or your spouse was active in the business, you may be able to pay them dividends without restrictions. But you should get tax advice on Tax on Split Income (TOSI) rules that may cause dividends to be taxed at a higher tax rate.
Adding a shareholder to a corporation can be complex and it requires legal and tax advice and the resulting fees. If you and your spouse can equalize your incomes in retirement using other techniques, or if the corporate savings are modest relative to your other assets, adding a spouse as a shareholder may not be worth the cost and effort.
Keep in mind that 50% of defined benefit pension income can be split with a spouse, as well as 50% of registered retirement income fund (RRIF) withdrawals at 65 or later. So, splitting corporate dividends may not be necessary.
A business owner with a lot of corporate assets may keep their corporation throughout retirement and will have more tax, estate and investment planning considerations. Some combination of corporate dividends along with RRSP/RRIF, non-registered, and TFSA withdrawals should be considered from year to year to try to balance annual and lifetime taxes, as well as tax on death.
When a corporation pays a dividend to a shareholder, it may result in a corporate tax refund that offsets the personal tax the shareholder pays to receive it. Corporations pay refundable dividend tax on corporate investment income each year and paying out taxable dividends to a shareholder may recover some of this tax. It may make sense to pay dividends to yourself each year to at least recover this refundable tax. Corporate tax refunds may be more than the personal tax you pay, resulting in a net benefit.
Corporations also have a capital dividend account (CDA) that can be used to take out tax-free withdrawals. When a corporation realizes a capital gain on an investment, one-half of the gain is taxable and one-half is tax-free, just like how capital gains are taxed for an individual.
A corporation gets to track a notional account called a capital dividend account that represents the tax-free half of capital gains. This CDA can be paid out tax-free to shareholders and for those with low or modest personal income, paying out CDA each year may be advisable.
In other cases, a capital dividend can be declared but not paid out and converted to a shareholder loan that can be withdrawn tax-free later.
Other income options for retired business owners
Business owners with significant corporate savings may benefit from more advanced concepts like an estate freeze, whereby future corporate growth accrues to children instead of to parents. This could reduce tax payable on the death of a business owner.
Life insurance may also be an effective way to reduce tax on corporate assets on death and get more after-tax inheritance into the hands of beneficiaries.
There are a lot of considerations for how retired business owners use their corporate savings to fund their retirement and to maximize their estate value. They should be seeking input from their accountant and other professionals before and after retiring to develop a plan for how corporate savings and other assets and pensions can be best integrated.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.