Even Albert Einstein, a man with a brain capable of solving the most complex physics equations, stumbled when it came to taxes. “The hardest thing in the world to understand,” he said, “is the income tax.” These days, tax advice is everywhere. TV ‘experts’, newspaper columnists and social media influencers will dispense tips on how to keep more of your money, but these brush strokes, at best, aren’t suitable for everyone and, at worst, perpetrate damaging misconceptions about certain benefits and how to use them.
For investors, these can be misleading and, without the help of an advisor, potentially damaging to your retirement. Here are a few myths explained and busted!
Corporate Dividend Versus Regular Income
Many people get caught in this dilemma and question why they need a regular income when it’s taxed at a higher rate. First, let’s highlight the two types of dividends – eligible and non-eligible.
Eligible dividends are usually received from public corporations that don’t receive small business deductions, or private companies with high earnings (net income over the $500,000 small business deduction). These companies pay corporate tax at higher rates than small businesses. Eligible dividends are, therefore, “grossed-up” to reflect corporate income tax already paid and then a dividend tax credit is included to reflect the higher rate of taxes paid.
Non-eligible dividends, meanwhile, are received from small business corporations that earn under $500,000 of net income. These are also “grossed-up” and given a dividend tax credit. However, the percentages used are different than for eligible dividends to reflect corporate tax being paid at a lower rate. Currently, the gross-up rate is 38% for eligible dividends and 15% for non-eligible dividends.
Ultimately, dividends are taxed at lesser rates than employment income. For someone in the top tax bracket in Ontario, eligible dividends are taxed at 39.34%, while non-eligible are taxed at 47.74%, compared with their salary which is taxed at 53.5%. This begs the question: why not pay yourself only in dividends?
It’s important to realize that doing so could have serious repercussions for RRSP contribution room and CPP benefits. For the latter, to receive the maximum amount upon retirement, you must have contributed for at least 39 of the 47 years from ages 18 to 65 based on the yearly annual pensionable earnings (YMPE). The YMPE keeps increasing, its inflation indexed, and for 2023, has been set at $66,600. Failure to maximise this through income could result in you receiving a reduced CPP when it’s time to collect.
A failure to contribute to your CPP will also affect the amount you could receive if applying for CPP disability benefit, available for those unable to work and are under 65. To meet the minimum requirements, you must have contributed to the CPP in four of the past six years, or have contributed for at least 25 years, including three of the past six.
For your RRSP, no salary means you would fail to generate any contribution room to defer taxes until retirement withdrawals. However, if your RRSP and CPP contributions are maxed, there’s no additional benefit to paying yourself a salary and increased dividends would be potentially more tax efficient.
Long-term financial planning, and regular assessment of your salary (i.e., not setting it at a certain level then forgetting about it) are required to be as tax efficient as possible and to ensure you receive the full benefit of both your RRSP and CPP. Setting up a corporation and getting paid in dividends may, on the face of it, feel like a win, but you may not be optimizing your finances in the process.
The Stellar Saver: RRSP and RRIFs
Registered Retirement Savings Plan (RRSP) contributions are a crucial part of tax planning and enthusiastic saving is generally hailed. However, there are two dangers to consider. The first and most obvious is the risk of incurring an over-contribution penalty. According to the CRA, you must pay a tax of 1% per month on excess contributions that exceed your RRSP deduction limit by more than $2,000.
A more long-term repercussion of loading up your RRSP without proper planning is that, in some cases, you will be in the same tax bracket or higher in retirement. Short term, you get a deferral and some dollars for a nice holiday or new TV, but in the long term, you will pay more taxes.
Another consensus move is, once your RRSP has been transitioned into a Registered Retirement Income Fund (RRIF), to defer your RRIF withdrawals to later in retirement (you must make this conversion in the year you turn 71 at the latest). But this doesn’t always make sense. If there is a period of lower taxation in early retirement, it’s possible to methodically withdraw money tax efficiently in your early retirement years.
Another nuance often missed is if you defer and defer, and there is a big discrepancy in the age of you and your spouse - there is a risk your partner could inherit a huge RRSP but have no one to income split with. Income splitting is the transferring of income from a high-income family member to a lower-income family member to reduce the overall tax paid. Therefore, consider splitting the older spouse’s RRSP to a RRIF at 65 or 60 to optimize the years you are both alive.
After a certain amount (of income) - $81,761 for 2022, $86,912 for 2023 – the government claws back your OAS. For every dollar of income above the threshold the amount of pension is reduced by 15 cents until it hits the maximum amount ($133,142) by which point you receive nothing. Some people do not realize that this amount is calculated upon the grossed up dividend before the tax credit, so they’re shooting themselves in the foot by taking a substantial dividend. If it’s $15,000 or $20,000 dividend, no bother, but if it’s a $70,000 dividend each year, that will start eroding your OAS.
For many high earners this is a foregone cost, but OAS is an emotive benefit for many – maybe because it’s viewed as more of a right than choice - despite being a relatively modest sum. For eligible dividends for an investment company, the before and after gross-up figure (dividend x1.38) is a big jump and forgetting that, and assuming you’re under the threshold, can have a significant impact on your OAS.
Freeze … Don’t Do It
Early withdrawal goes against the norm when it comes to estate freezes, a strategy where the owner of an estate seeks to transfer assets to his or her beneficiaries without tax consequences. Often, the owner will exchange their common shares in their company for preferreds, so the second generation benefits from the growth of a new series of common shares. However, it sometimes makes sense to redeem those frozen preferred shares early if you need it for lifestyle expenses, for example. You could even take the money out as eligible dividends, which might give you a more positive tax result, or even capital dividends. Rather than let them sit there, you could get more tax efficiency if you started redeeming them earlier than conventional wisdom suggests.
Each situation is, of course, different and even Einstein would have benefitted from professional advice. Speak to your accountant to find out the best strategy for you to achieve tax efficiency for you and your family.