In this second edition of retirement planning, we’ll explore strategies specifically tailored for entrepreneurs and self-employed Canadian immigrants. In the previous post, I discussed the non-financial aspect of defining your lifestyle. Although I won't revisit this topic here, it does not imply that, as a self-employed individual, you should overlook that fundamental step - after all, you didn't brave a new country to work forever!
Today, we’ll address the following topics: how to strategically extract profits out of business, setting up your pension and protecting your family’s lifestyle.
Salary vs. Dividends: The Chess Game of Corporate Compensation
You might be scratching your head right now, wondering why you should care about salary and dividends when planning for retirement. The relationship between these two corporate profit extraction methods offers significant benefits to your future self, spanning multiple planning categories such as taxation, retirement benefits and long-term financial security. However, the right approach will depend on a multitude of factors.
Despite the more favourable tax efficiency and flexibility of dividends compared to salary, salary facilitates the efficient extraction of corporate profits. It allows you to distribute your investments across various tax-efficient personal accounts, such as the TFSA and RRSP mentioned in the previous blog. Additionally, earning a salary allows you to access a lifetime indexed guaranteed income upon retirement, known as CPP, a benefit many newcomers overlook in their early planning stages.
Moreover, without salary earnings, you miss out on the potential to grow your investments on a tax-deferred basis through RRSPs and IPPs (Individual Pension Plans), as you cannot generate RRSP/IPP rooms without salary. Furthermore, you cannot contribute to CPP without salary earnings, which is unfortunate since you could be forfeiting over $353,000 in lifetime benefits, assuming you are 65 today and live until age 90. That is a significant amount of money left unclaimed due to a lack of planning if you only collect dividends, like leaving a winning lottery ticket in the pocket of jeans headed for the washing machine!
A practical approach would be determining how much salary income you’d need to maximize your CPP contribution, generate sufficient RRSP room to fund your retirement goals, and qualify for earned and tested benefits like Child Care.
From a tax perspective, extracting profits from the corporation as salary allows the corporation to deduct it as an expense, which will lower the taxable income for the corporation. Therefore, if you are a corporation earning more than the allowable Small Business Deduction (SBD) limit of $500,000, salary distribution will bring you below this threshold, leaving more cash on hand to be invested in both the corporation tax-deferred and personal through CPP and RRSP/IPP contributions.
Ultimately, understanding how much after-tax income you’ll need for your current and future needs will help determine how much of each income type you should utilize. Dividends are a great way to access those corporate notional account balances, starting with the Capital Dividend Account (CDA), followed by the Eligible Refundable Dividend Tax on Hand (eRDTOH), and then the Non-Refundable Dividend Tax on Hand (NRDTOH). Whether you choose dividends or salary as the top-up will depend on your needs, much like how you balance your homeland traditions with newly adopted Canadian customs!
Individual Pension Plans (IPP) – RRSPs On Steroids
Although you’ve sacrificed a lot in building your company, do not assume that your exit will be enough to fund your retirement lifestyle. There are many factors, both uncontrollable and controllable, that will impact how much net proceeds you’d earn from the sale. So, diversify your savings vehicles and reduce exposure to one source of an unknown income stream through IPP (Individual Pension Plans).
What are IPPs? Think of them as your personal defined benefit (DB) pension plan for incorporated business owners. They allow owners with a high and stable salary (salary being the key) to make more significant tax-deductible contributions than are typically permitted in an RRSP. It's like having an RRSP that hit the gym and bulked up specifically for business owners!
Additionally, to fully take advantage of the IPP, you need a T4 income of $100,000 or more and be over 40. If you're younger and have a similar income, you’re better off maxing out your RRSPs since IPP contributions surpass RRSPs around 40. An IPP functions like an RRSP, employing an investment account you control, unlike a typical DB plan, to grow your retirement benefits over time.
As you can see, as you and your business grow, there will come a point when the contribution room provided by an RRSP may no longer be sufficient to accommodate your retirement style due to the annual RRSP limit. In this case, the IPP shines with an extra 67% more contribution room to age 65. Another bonus is that you can claim past years of service (going back to 1991 if you’ve been incorporated that long) and include employed family members, making it easy to pass your wealth to the next generation. Contributions are determined by age; the older you are, the more your business can contribute to the plan (GBL). It's one of the few situations where getting older comes with increasing financial advantages!
Furthermore, when discussing how to maximize the sale of your business, utilizing the IPP can help reduce passive income in a corporation, which is crucial for making your company eligible for the Lifetime Capital Gains Tax Exemption (LCGE), as mentioned in my Smart Tax Moves blog. At retirement, you have the same available options as someone with a regular DB pension would have. You can commute the allowable value under the Income Tax Act (ITA) and set up a Locked-In Retirement account (LRIF) or trigger the monthly pension from the plan.
Protecting Your Family’s Lifestyle: The Safety Net Every Immigrant Entrepreneur Needs
Another critical aspect of retirement planning for business owners like yourself is insurance planning. You cannot have one without the other; it would be like trying to survive a Canadian winter without a proper coat! Building a successful business represents personal achievement and lays the foundation for your family’s financial security. There are three types of insurance to consider when protecting your business and lifestyle: Life, Critical Illness, and Disability Insurance. However, today, we’ll focus on life insurance.
In protecting your family's interests, spending enough time understanding the lifestyle your family hopes to have even after your passing is crucial. Are there debts that must be addressed? Will there be enough money to cover not just the cost of raising your children but also to fund their education? You’ll need to account for these regardless of the value of your business. Additionally, you’ll need to establish whether you require personal or corporate life insurance, especially if you have family members who may or may not be involved in running the business. For instance, a corporate-owned life insurance policy can assist those involved in the company to use the benefit payout to fund the purchase of your shares from your estate. However, this may leave insufficient funds to cover the inheritance of those not involved in your business. This is when a personally owned life policy can help close the inheritance funding gap to equalize your estate.
Suppose you are going to set up a corporate life policy. In that case, there are a few things you want to keep in mind, especially if your company has other shareholders, whether they are family members or third parties, and that is a shareholders’ agreement. First, if you have a corporate life policy, you want to ensure that the corporation is the beneficiary, not the shareholder. If you designate a shareholder as a beneficiary while the corporation pays premiums, you create a taxable event for the shareholder.
Secondly, a shareholders’ agreement, the equivalent of a business prenup (because some business partnerships last longer than marriages!), not only serves as a foundational contract between a company’s owners but also establishes clear instructions on how to deal with specific events such as succession and transition planning, ownership control, and conflict prevention. Why does this matter for corporately held life insurance? It compels the corporation and surviving shareholders to use the proceeds to buy out your share when you pass. This way, the business doesn’t have to use its funds and ensures your estate beneficiaries receive their inheritance.
Take note that depending on how early you are in your immigration journey and your residency status, there may be some coverage restrictions. For instance, if you are still under a temporary status, like a work permit, you might be ineligible for premium waivers or accidental death riders. Nonetheless, if you are a permanent resident, you have access to full eligibility for life insurance like any other Canadian citizen.
Your Canadian Legacy: More Than Just Business Success
As an immigrant entrepreneur in Canada, you've already demonstrated your resilience and determination by building a successful business in a new country. Your retirement planning deserves the same level of commitment and strategic thinking. Just as you navigated the complexities of a new business environment, you can master the Canadian retirement landscape with thoughtful planning.
Remember that the wealth you're building isn't merely measured in dollars and cents; it represents security for your family, opportunities for future generations, and the freedom to enjoy the life you've worked so hard to create in your adopted homeland.
