We all follow certain rules of thumb—whether it’s drinking eight glasses of water daily, or cleaning the gutters annually, these general guidelines help us maintain balance in our lives. But when it comes to managing excess funds within a corporation, is there a universal rule to consider?
Many incorporated business owners stick to what they know (or what they have been told), and bank on the tax-deferred advantage of keeping excess funds within their corporation. This may be helpful as a rule of thumb, however, it may not always be the best strategy to maximize your long-term financial well-being.
An alternative is to pay out additional taxable income to contribute to a Tax Free Savings Account (TFSA).
TFSAs have transformed the landscape for personal savings and investing for Canadians, but for incorporated individuals, paying out retained earnings to invest in a TFSA remains a gray area. While the rule of thumb is productive, generally, it is more advantageous to pay out some retained earnings to invest in a TFSA rather than keeping all investments within the corporation and deferring personal tax for as long as possible.
The Benefits of Withdrawing Retained Earnings to Invest in a TFSA
- Tax-Free Investment Growth: Allowing your investments to grow without the associated tax drag from annual distributions.
- Insulation from Changes to Corporate Tax Policies: As we’ve seen recently, tax policy can change dramatically. Different types of investment accounts have varying tax characteristics. Using various accounts helps to mitigate tax exposure.
- Increased Investment Flexibility: A TFSA offers greater flexibility compared to a corporate investment account. Allowing you to rebalance or modify your portfolio without incurring capital gains taxes, you can make strategic shifts that align with your financial goals.
The Long Game
Business owners understand that time is their most important ally for growing their investments. The tax-free nature of TFSAs amplifies the benefits of compounding in the following ways:
- Playing Catch Up: Initially withdrawing retained earnings to invest in a TFSA will trigger personal tax and reduce the amount available to invest. However, the advantage of tax-free growth allows your TFSA to catch up and surpass corporate investments over time. Unlike a TFSA, a corporate investment account will have a pre- and post-tax rate of return.
- Funding a Milestone (Tax-free Withdrawals): The TFSA offers a unique advantage in that it provides not just a means to save, but a tax efficient way to fund significant life milestones. This is particularly helpful when life deals you a particularly large, one off expense (paying for a renovation, wedding, etc.)
The Exception
It is important to note that this financial strategy may not be suitable for every situation.
For incorporated business owners whose investment portfolios target holdings that generate deferred capital gains and eligible dividends, the tax deferral advantage of keeping funds within a corporation may provide greater benefits and outperform a TFSA over time.
However, few investors defer all capital gains indefinitely, and most maintain a diversified portfolio that generates taxable investment income, making it beneficial to allocate some funds to a TFSA.
If you’re aiming to maximize your long-term wealth, for most, investing in a TFSA makes sense. From reducing taxable passive income in a corporation, to funding milestone purchases or expenses, a TFSA is an indispensable arrow in your financial planning quiver.
Looking for ways to get started? Speak to an advisor at CPFG and take your planning to the next level.
