Linda is approaching retirement with cash in her corporation. She wonders how to withdraw it before or after retirement.
I work as a self-employed IT contractor. I am incorporated. Over the years I have accumulated about $100,000 in my business account, over and above what I need to carry operating expenses. I am about five years out of retirement, maybe less than that if I go for a semi-retired approach. I would like to know the best strategy for withdrawing the money from my business.
I am aware I can pay myself a dividend, but I thought a business had to have earnings in order to declare a dividend. Is that the case? As I am a one-person operation, am I even allowed to declare dividends anymore? I heard the tax laws changed recently.
Linda, you have a corporation and $100,000 of cash you have saved. A common mistake by business owners is thinking they cannot invest this money. A corporation can buy guaranteed investment certificates, stocks, bonds, mutual funds, and exchange traded funds. It can work with an investment advisor or open a self-directed brokerage account. A corporation can even buy a rental property or invest in another business.
But let’s go over some notes on incorporating, first.
Why incorporate a personal business
One of the benefits of incorporation is the ability to leave savings in the corporation, when it’s not needed for personal use. An incorporated business owner who does this can defer over 40% tax on their earnings.
There are other reasons to incorporate. One is to limit your personal liability, but liability can also be mitigated by purchasing insurance. Some people feel a corporation conveys a more professional business appearance, which may not matter if the business is essentially you. Another reason is when you have business partners.
What’s involved in incorporating a business
Incorporation costs money up front and ongoing. There are legal fees and accounting fees. Bank fees are higher as well. So, unless there is a benefit to incorporation, a business owner should consider operating as an unincorporated sole proprietor, reporting their earnings on their personal tax return. A business does not need to be incorporated.
Paying yourself a salary from a corporation
An owner manager who owns shares of their corporation, and is also an employee, can pay themselves in different ways: An employee can be paid a salary. A shareholder can be paid a dividend on their shares.
When a corporation pays a salary, it deducts that salary from its business income. So, say your corporation earns $100,000 per year, and you pay $75,000 out as a salary. The salary would reduce the corporation’s taxable income to $25,000 (ignoring other business expenses).
Say you live in Saskatchewan, Linda. Your corporation, assuming it qualified for the small business deduction, would pay 11% corporate tax on that $25,000 of income, leaving $22,250 in cash. I suspect over time this is how the $100,000 of cash you have currently has been accumulated.
What is a dividend?
A dividend is a payment of after-tax corporate savings to a shareholder. Dividends are taxed personally at lower tax rates than salary to account for the fact that corporate tax was already paid on the earnings. In an ideal world, the dividend would be taxed at 11% less when paid to you and result in perfect integration in my example but the actual difference can vary. The tax rate is always lower on dividends than salary.
In any event, Linda, you could pay out your $100,000 in cash as dividends now, over the next few years, or in retirement.
What you can do with dividends
If you did it now, you would pay a lot of tax as the dividends would be in addition to your salary for the year. But if you have room to contribute to a registered retirement savings plan (RRSP), you could use the money to be invested and growth tax deferred. A RRSP contribution could more than offset the tax on the dividend.
For example, if you have a $75,000 salary, pay a $100,000 dividend, and have $100,000 of RRSP room to make a RRSP contribution, the net result could be a $7,000 tax refund, fully offsetting the tax on the dividend (assuming Saskatchewan residency and ignoring other deductions or credits).
If you paid the dividends over the next few years, you could do this to top up your salary assuming you are going to semi-retire, as you alluded to doing. As an example, if your business income went from $100,000 to $50,000, you might reduce your salary to $50,000 and take some dividends to top up your personal cash flow needs.