When it comes to creating an optimal compensation strategy plan, there’s a lot to navigate. And while there may be a plethora of general rules floating around on the internet, each individual’s optimal strategy is ultimately going to be dependent on their unique situation. That is why we’re using today’s conversation to break down the findings of our mental model algorithm. Tuning in you’ll hear a detailed explanation of the five steps for creating an optimal compensation strategy plan, and how to apply them. Find out how to plan your consumption, account for mandatory income, clear out notional accounts, use salary to make up the difference, and utilize salary dollars that aren’t for spending. We also cover key areas, like Canada Child Benefit (CCB) clawbacks, incorporating income splitting when using your salary, and how to pay yourself a salary bonus to bring the corporate active income down. Join us today to learn how you can implement a dynamic salary and dividend strategy for optimal compensation, and much more. There’s a lot to unpack here, so get your note-taking devices ready, and let’s get started!
[0:00:02] BF: Welcome to the Money Scope Podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, portfolio manager and Head of Research at PWL Capital and Dr. Mark Soth, AKA the Loonie Doctor.
[0:00:17] BF: Welcome to episode 13 of the Money Scope Podcast.
[0:00:20] MS: Yeah, so in the last episode, we went through some of the nuts and bolts about how to pay yourself through a corporation, talked about business deductions and taxable personal benefits, how tax integration works to try to make the total personal and business tax the same, and there are imperfections. Generally, they favour using salary, but we also pointed out some favourable anomalies, as well as that.
[0:00:41] BF: That last episode was crazy. When we were doing it, I was like, “Man, it can’t get crazier than this.” Then this episode happened.
[0:00:48] MS: This one’s been cooking for a while.
[0:00:50] BF: This episode’s crazy. Anyway, in the last episode, we also covered how corporations can reduce your taxes by smoothing your personal income over time to keep it in lower tax brackets, both for short-term fluctuations and over your lifespan. We also talked about practical strategies to help with big one-off expenses, like using shareholder loans, or the capital dividend account.
[0:01:09] MS: We bring up that previous knowledge base that we’ve been building, because that really comes together. We combine all of that together, plus the corporate invest and taxation that we’ve talked about. That all comes together into what we’re going to talk about today, which is optimal compensation strategies. It pulls from all of those different areas, where the rubber hits the road with corporate tax planning. It’s complicated, because it’s a blend of those interactions between your active business income, your passive income in your corporation, plus your personal consumption, which is what drives how much money is coming out and then how are you going to take that out in the best way, not just this year, but over your lifespan.
[0:01:45] BF: Yeah. You mentioned, Mark, this episode has been in the works for a while and it has been. We gave ourselves a bunch of runway by pre-recording a whole bunch of the early episodes. We were like, “Yay, we’ll have plenty of time to –” This episode ate up a lot of the time that we bought ourselves earlier on in our series. But it is complicated and I think we broke some new ground in this episode. You’re not going to find the type of stuff that we’ve looked at in this episode that you’re about to listen to. I don’t think it’s anywhere. People have done great work on some adjacent topics, but I don’t think this level of thinking, at least from what I’ve found, and I’ve looked a lot, just doesn’t exist anywhere else.
[0:02:18] MS: Part of why it took us a long time, there’s both aspects of this that we’ve been struggling with this. It’s great, because together we’re able actually to model some of it out and actually, we built some models that tested out things that we’ve both been trying to figure out the optimal answer for. I know one of them in particular. I’ve waffled back and forth on multiple times now, but I think we’ve actually pulled it together and that background work, hopefully, we’ve been able to distil that into some big algorithmic type of decision tree type of information.
That said, though, any model that we make is going to be imperfect. There’s unpredictable future events that could change it. You have to look into the future when you’re considering about corporate compensation. Every one individual situation is going to be a little bit different too, which actually tried to get into a lot of those nooks and crannies about some of the uncommon things that we still get asked about, but we can’t really make specific tax planning advice. We can give a bunch of general ideas, and the idea is that you take that and use that to discuss with whoever you’re doing your tax planning with to help you out.
I have made a corporate to personal salary dividend optimizer calculator that I have on my website, the looniedoctor.ca, which I’ve had running this algorithm for a while now. We’ve fine-tuned it a bit more as we started on roll this episode, too. There is that there. But that’s meant, along with the information that we’re talking about today to be a start point for discussion to bring up some things that may not otherwise be brought up.
[0:03:44] BF: You mentioned algorithms. We really tried to make this episode into a way to communicate at least the mental model version of an algorithm to think through where your compensation should come from. Making it an algorithm in a computer is probably necessary to do this really well, like the calculator on your site, Mark, because it is really complicated and there are a lot of moving parts. I think listening to this episode is going to be time well spent for people who need to learn this information, because like we said, it’s not stuff that is easy to find.
There are a ton of rules of thumb that float around out there on the Internet. Only use dividends as the always optimal compensation strategy, or use your salary to max out your RRSP first. Take maximum salary, even if you don’t need it, to max out the RRSP room. Those are both rules of thumb. The optimal solution from what we’ve found for any given year is usually going to be a mix of different streams of income. There are also other aspects, or strategies that are often overlooked if you don’t know to bring them up when you’re talking to the professionals that you’re dealing with.
[0:04:48] MS: Yeah. Then just to reiterate that this is actually useful information, which I’ll probably have to do a blog post about our own situation, but we started paying attention to this in 2017. Then as we learn more, we’ve fine-tuned it more, even though our personal consumption rose for a few years into that, our combined personal and corporate tax bills actually dropped pretty significantly. That was just through some planning and bringing up some different ideas, we were able to spend more while paying less tax. This is not just some placebo. This is something that can really change your outcome.
[0:05:19] BF: Yeah, it’s important stuff. Let’s start by talking about optimizing integration. We know from the previous episode that tax integration generally favours salary over the combination of paying corporate tax on active income, plus personal tax when it all flows through a dividend. That’s true in isolation. But paying dividends from the corporation also helps to keep the notional accounts flowing, the GRIP and the RDTOH accounts, and then the CDA. Plus, paying money out now doesn’t always make sense, because you might not need the income. Paying only the corporate portion of tax now, investing retained earnings in the corporation and then paying out dividends personally later gives you the benefit of tax deferral, because you’re not paying the personal portion of tax.
Anyone earning a large active corporate income, spending enough to justify a salary that maxes the RRSP and also requiring more money to live on beyond that may not have much of a dilemma. Relatively easy in those cases. They can pay the high salary, use dividends to meet any excess demand, and they’re going to keep the notional accounts flowing and max out their RRSP. But most business owners will need to choose a mix of salary and dividends that balances all these issues, respecting the benefits of tax deferral. It gets fairly complicated.
Having a spouse as an additional variable in thinking through this, depending on whether they can earn a salary, working for the corporation, whether they can receive dividends excluded from TOSI is also going to factor into the equation in thinking through this. If you can dividend split with a spouse shareholder, then splitting the dividends to equalize the taxable incomes can further reduce the amount of money required to fund personal after-tax spending. We talked in more detail about that in the last episode, but it’s worth keeping in mind as we discuss optimal compensation in this episode.
[0:07:00] MS: Yeah. It’s also important to remember that this also isn’t a static situation. The optimal mix of salary and dividends is going to change over time as the corporation’s active income changes and as a passive income changes. We’re going to spend the rest of this episode unpacking all of those considerations and try to formulate a systematic approach to plan corporate compensation.
Step one for that is going to be to start with a consumption plan. Compensation is really meant to fuel our consumption. The first thing that you would consider when planning how to move money out of your corporation is asking, how much money do you need personally now and also into the near future? when you do that, that includes after-tax money needed for personal consumption, debt repayment, and contributions to your registered investment accounts as well.
Remember that the TFSA and RESP require after-tax personal money for you to contribute to that, so you must add those contributions into your budget. The other thing is figuring out how much you need to fund your RRSP is a bit trickier. It’s dependent on how much salary you’ve paid yourself the previous year. But as you pay yourself more salary to meet your consumption needs, we also get more RRSP room. You have to plan how much extra cash do you need to put into that extra RRSP space that you’ve created by paying out salary. You can get into this bit of a feedback loop.
The same thing happens with FHSA contributions, because you can deduct those against income as well. You get a feedback loop up until the point where you hit the maximum contribution limit for those pre-tax accounts. I would total up my planned consumption and my registered account contributions for a year to set a baseline of after-tax cash flow that I need as my target.
The other consumption items to plan are big chunky spends that you may have coming up over the next couple of years. If you aren’t destined to be in the top tax bracket no matter what you do, then by planning that way, for that splurge, you can maybe take out some income over several years, instead of just one big chunk and smooth that out to keep yourself into lower tax brackets. We talked about ways to do that. Part of it is this compensation we’re talking about today. You could also use a shareholder loan to help spread it out an extra year, like we talked about in episode 12. Putting into this part of your compensation planning can actually smooth it out even further over a longer period of time. When you take that extra cash out, if you’re taking it out early to smooth it out, you can park that into personally into some products that suit your risk tolerance and your purpose, like we talked about back in episode five when we’re talking about saving money.
[0:09:36] BF: The other thing that I think it’s worth keeping an eye on is the big picture, smoothing consumption over your total lifespan, as opposed to just the near term. For a corporation to function efficiently, you have to be paying out enough dividends to keep the refundable taxes, like RDTOH, flowing back to your corporation. Otherwise, it’s just sitting there being eroded to inflation, or utilizing the GRIP to distribute lower tax-eligible dividends, or even tax-free dividends through the capital dividend account.
Early on in corporate accumulation, most corporation owners have no problem spending enough to personally use up the notional accounts. But if you keep personal spending low and build a massive corporation, and those things go hand in hand, because you’re not spending much, you’re retaining more, it will eventually require you to move larger amounts of money out later to keep the corporation tax efficient. Otherwise, you end up with a bunch of trapped RDTOH, or corporate bloat, as we called it in a previous episode.
With that in mind, you may be better off smoothing some of that personal tax out pre-emptively. Knowing that you may end up in that situation in the future, there can be things that you want to do earlier to avoid that issue, or at least defer. On the other side of that equation is that corporate tax deferral is super powerful. Keeping some money invested and growing in the corporation over time is also important.
[0:10:53] MS: Still, considering keeping your spending now and in the future, that’s going to matter a lot. Tax deferral works best when you defer from a high tax right now to a lower one in the future, and not the other way around. We’ll come back to that with some of our modelling towards the end of the episode.
That was step one. Starting with our consumption. Step two is you have to account for mandatory income, before you start talking about stuff that you actually control. One of the benefits of a corporation is that it acts as a dam for your taxable income, putting you in control of the flow of the money coming out of it, so you can regulate that.
While it likely makes sense to take some money out of your corporation each year to smooth your income out over your lifespan, you’ll generally retain a significant portion within the corporation. This is one of the key reasons to have a corporation in the first place. Some of the corporate tax rules encourage you to move money out of the corporation ultimately. You need to do that at some point and you may not control that with your personal finances in contrast to that.
If you have income that you get outside of the corporation, it comes without you controlling it. For example, you and your spouse may have income from a job outside of the corporation. That’s money that’s going to come in, no matter what you do. Similarly, you may also have personal rental properties, or other investments personally that generate income. That’s money that’s going to come in and get taxed each year. Later on in life, pension income from CPP, OAS, or other pension plans could enter into the mix. This is all money that you receive the cash each year, you pay the tax each year, you don’t regulate it. Since these income sources are flowing to you, hitting your tax return, no matter what, it makes sense to account for those first, so you have that come in. Now you need to decide how you’re going to take money out of your corporation to make up for the shortfall between that mandatory income and what you need to meet your spending target.
[0:12:37] BF: I think this highlights the general concept that accounting for both the personal and corporate taxes is super important. As we discussed in the last episode, tax integration attempts to make taxpayers indifferent about whether they earn income personally or in their corporation, but there are all sorts of nuances buried in there that make thoughtful tax planning a pretty valuable exercise. We’ve gone through step one, which is figuring out your consumption plan, how much you want to spend, or you need to spend. Step two, what’s your mandatory income? You know you need to spend some amount. If you know that you have some amount of income that you have no control over outside of your corporation, how much is that? Because you don’t want to take extra out of your corporation, obviously.
Step three in our mental model algorithm is clearing out notional accounts. Once you know the spending needs and mandatory income sources, the next step is to check what your notional account balances are. When you have a gap between personal cash flow needs and mandatory income, the most tax efficient ways to move money out of the corporation to fill that gap are going to be related to the notional accounts. For example, paying a dividend that triggers a corporate tax refund by releasing E or NRDTOH using eligible dividends allowed by a GRIP balance from a corporate taxes paid at the general business rate, or the holy grail of tax efficient income, although not in all cases, as we’ll talk about later, a personal tax-free capital dividend using a positive CDA balance. Now remember, the notional accounts exist on paper for corporate tax integration purposes, but they do represent real money in terms of tax savings, or refunds.
[0:14:08] MS: Yeah. I think real money is actually probably a poor choice of words here, and we set that up, because one of the important features of notional accounts is that they’re actually tracked in nominal dollars, as opposed to inflation-adjusted real dollars. This means that the economic value of the notional accounts will be eroded over time by inflation if they’re not used up. In addition to the refund, or the tax savings, that is the other reason why prioritizing emptying your corporation’s notional accounts is important. The notional accounts that translate to the highest tax efficiency are actually going to erode the fastest in terms of real buying power when you factor in inflation. That’s going to inform our priority in distributing them, not just for the tax savings now, but also to use it before you lose it.
[0:14:51] BF: Yeah. Use it or lose it. We’ve made this public service announcement a few times throughout this podcast series, Mark, but I think it’s worth saying again. Check your notional account balances.
[0:15:00] MS: Yes.
[0:15:00] BF: We’ve both seen people with just massive CDA balances that are just sitting there eroding and not being used to fund consumption. Ask your accountant what your notional account balances are, or some accountants don’t use the term notional accounts. Ask what your capital dividend account balances, or what your RDTOH account balances.
[0:15:19] MS: The money’s going to come out sometime and you’d rather have it come out in a controlled fashion than get in corporate bloat in the elevator.
[0:15:25] BF: Okay, so before we proceed here, just a quick warning, thinking about money in terms of inflation-adjusted, real dollars can be a bit mind-bending, especially when you add in the layers of corporate and personal tax that we’re going to be talking about, but it’s key to understanding why paying dividends to use notional accounts is important. Now, as much as it might get mind-bending here, does end up with some pretty easy to understand takeaways and guidelines. But because of the way our brains work, we both think it’s pretty important to explain why these things work the way that they do, so that people are equipped with that knowledge. Been our experience that people often don’t get this. They haven’t thought about it in these terms.
[0:15:57] MS: No. We want to make sure what we’re saying is accurate, too, because there’s little nuances here and there that could change things. If your account is saying something that’s different from what we talked about today, it might be that they’re thinking about one of these nuances. We wanted to make sure we put all those nuances out there.
[0:16:11] BF: Also, true. Okay, so we’re going to start with the capital dividend account. Now it’s generally the most valuable notional account. That’s because it allows you to pay out a tax-free capital dividend to a shareholder. Now there is usually an accounting fee for filing the special election to do that, but the cost is hopefully minimal. It’ll change from accountant to accountant.
There are some exceptions where releasing RDTOH may be more or less valuable than using a CDA balance. That was my comment earlier about usually this being the Holy Grail, but not always. Mark will come back to that at the end of this section. But in general, savings in a current tax year using a tax-free capital dividend compared to using a regularly dividend, or salary to get the same amount of after-tax money to spend personally is going to be huge for most people.
Just as a simple example, if I have a $100 in my capital dividend account and my CDA account, I can give $100 capital dividend to a shareholder. At the top marginal rates in Ontario, to get the same $100 after-tax amount using salary, I would have to pay out $214. Alternatively, if I were going to use non-eligible dividend, it would be $194. Either way, that’s either $94, or $114 more paid out of the corporation as regular compensation than if I were to use a capital dividend to get the same personal after-tax amount.
[0:17:24] MS: Yeah. Importantly, that $100 in the CDA is tractive nominal dollars, like we mentioned. Let’s say they don’t use it for a few years. What used to buy $100 now buys $80 worth of goods. That could be a long time, or it could be a few years, like we’ve experienced recently. But that erosion due to inflation is a real thing in terms of buying power. I would have to make up for that lost $20 of buying power with either even more salary, or some taxable dividends to bridge that gap.
In this case, it would require $38 of non-eligible dividends to make up for that $20 gap after taxes that I’ve lost to inflation. If you put all that into inflation, just at real dollars, the corporation would have had paid out $80 in capital dividends, so that’s $80 in real dollars, plus $38 in non-eligible dividends, so for a total of $118. That’s to get that same $100 of buying power that I would have had if I’d used the CDA right away. By not using it right away, I have to make up that difference.
When considering how to pay myself, the first thing that I would do is to check to see if I have a positive CDA balance worth using. When I say worth using, I mean that it has to be large enough to justify the accounting cost. The most recent CDA balance can be found on your corporate tax return, or by talking to your accountant. You have to have a positive balance if you’ve realized capital gains on investments in the corporation, or donated appreciated stocks to charity. I say that a positive balance, because it’s important to realize that realized capital losses subtract from that CDA balance, it’s the net of your gains and your losses to have a net positive balance to use it.
Also, you cannot just give a capital to dividend based on the previous balance. When you’re going to do a capital dividend election, your accountant has to do a full accounting right up to the date of the special election when you’re going to give the dividends. There’s usually a fee for the accounting costs to do that for you.
[0:19:24] BF: Yeah. You got to be careful not to do any transactions while they’re in the process of filing. That’s another big one.
[0:19:29] MS: When we’ve done it, we’ve actually waited a little bit afterwards just to be on the safe side, because my accountant told me that CRA has no sense of humour about this issue. I dare, bear with caution.
[0:19:41] BF: Yeah. I don’t think they have a sense of humour on many issues, not just this one. I want to make a comment real quick before we keep going here. All the stuff that we’re talking about has been modelled in various ways. We’ve modelled it at PWL and Mark, you’ve modelled it as well. We’re not just saying stuff based on our opinions, or based on an individual rule for each concept. We’ve taken all of these ideas, put them into various types of software and then run full life cycle models to see what gives the best expected outcome. Which order of spending from notional accounts and salary and all that stuff gives the best expected outcome for different situations. We’re not just saying stuff. We’ve done the work.
[0:20:18] MS: No, and it’s important that you use the word life cycle, too, because it’s not just one year of taxes that matter. It’s how this unfolds over a long period of time that matters, because you have to have the money come out at some point. What you do now actually sets you up for what happens later on. You have more options available to you if you have plan as well.
[0:20:38] BF: Yeah. We’re talking about this in terms of just the general ideas. But we’ve taken those ideas, put them into algorithms in software that run through a full financial planning model and then made sure that what we’re saying actually is correct in the long run. Back to capital dividends though, what you were just saying there, Mark, makes it really important to be mindful of realizing capital losses in the corporation when you have a positive CDA balance that you might want to use. Because if you realize a capital loss, it reduces your CDA balance. If you’re looking at $100,000 CDA balance and you think, “Yes, I’m going to go buy an RV,” I don’t know if that’s enough for an RV. Probably not.
[0:21:09] MS: Incidentally, we’ve actually had to wait on changing losses and rebalancing till after the RV purchase before.
[0:21:15] BF: Perfect.
[0:21:16] MS: It’s a real example.
[0:21:17] BF: If you realize loss before you take the capital dividend out, then whoops, you don’t have access to those funds tax efficiently anymore. The other thing about capital dividends that’s worth noting is that because they’re not taxable, a capital dividend may be able to be paid to a non-voting shareholder without running afoul of the TOSI rules, which we’ve talked about in the last episode. If you don’t need to spend, or use funds from a capital dividend for registered account contributions, then a low-income shareholder spouse could invest them personally. Like we discuss in episode nine, second-generation income would be attributed to them and not attributed back to the income earner and tax at their low tax rates, which achieves some version of income splitting. This stuff gets super messy, super-fast.
Really important to get individual tax advice specific to the fact pattern of your situation. What I just said is technically allowed within the tax rules. There’s also the potential that CRA decides to apply GAR, the general anti-avoidance rules. That’s the big tiger they like to trot out to scare anyone. That tiger got more aggressive with recent changes to GAR. It’s basically like, if you happen to have a spouse shareholder who you can pay a capital dividend to, there’s no attribution. But if CRA can prove that you set up your corporate structures such that it would allow you to pay capital dividends to your spouse, they could apply GAR. I think that’s one way to think about the risk here, but that’s obviously very subject to interpretation.
[0:22:37] MS: Yeah, and there’s always that risk. The problem with the threat of the tiger is that it prevents you from doing totally legitimate things once in a while, then you’re leaving money on the table. If you’re doing it all the time in a very aggressive way, then you might raise some flags. I think that’s why talking to your accountant about this is important, because they have a sense of this unspoken stuff that is bantered back and forth between CRA and accountants that you probably aren’t privy to. There’s lots of stuff that there’s grey zone for, and it depends on how aggressive they want to be with the general anti-avoidance rule, which they’ve changed recently to make it more aggressive.
The other thing Ben mentioned at the beginning of this segment is that there are sometimes when using a taxable dividend to release RDTOH could be more cost effective than even a capital dividend. That sounds crazy, since capital dividend has no tax on it, but there are possible exceptions. I’ll just give one example of that. One possible exception really is in very low personal tax brackets. When the net personal tax on taxable dividends is significantly lower than the RDTOH refund, and I say significantly lower, because even when that money gets refunded back to your corporation, the value of that refund, you have to discount that, because at some point, that money actually still has to come out from the corporation into your personal hands, which requires you to pay some tax on it.
That 38% refund is probably worth less than that, depending on what your tax rate is in the future when you move that money out. Now, that’s mind bending and it’s complicated, because it depends on a future assumption about what your tax rate is going to be like down the road. There are times where it’s pretty clearly going to be beneficial. For example, if I were to pay $100 eligible dividend in the lowest tax bracket in Ontario, the effective personal tax rate on that would be actually negative 7%. It’s a non-refundable dividend tax credit, but you would offset that with some other income. Effectively on that, it would be negative 7% due to the enhanced dividend tax credit being higher than the marginal tax rate in that tax bracket. That’s less than zero tax that you would be having on a capital dividend. It’s even less than that.
Plus, even if you have enough RDTOH, you get a 38% refund on top of that. With our $100 eligible dividend, we get $38 refunded back to the corporation. Then to get that $38 out of the corporation later on, you do pay some personal tax on it. But if that’s at a relatively low tax rate too, let’s say it’s a non-eligible dividend in the lowest Ontario tax bracket, then there would be 9% tax on that $38. To put all of that together, all those different pots of money and taxes together, you’d have $34 after tax from the RDTOH refund after you pass it through as a non-eligible dividend sometime in the future, plus 7% extra dollars now, because your personal tax credit was higher than the tax you paid on the eligible dividend, plus you have the $100 of the eligible dividend itself.
You total that together as $141 for using a $100 eligible dividend to release the RDTOH compared to if you’d used $100 from giving a $100 capital dividend, you’d have $100. This is a case at the lowest tax bracket, where it can obviously work out into your favour. Now many people will fall somewhere in between, and we modelled this out at a constant current and future tax rate at different tax brackets. In Ontario, taxable incomes of under $107,000 might have more value locked up in the ERDTOH than they do in the CDA, just because of the way of all those different taxes and refunds workout, assuming that your tax bracket stays the same. That corresponds if you’re to take that $107,000 and make that into an eligible dividend and gross it up, that corresponds to about a $7,000 eligible dividend.
We also looked this outside of Ontario, we looked at Alberta, BC, and Saskatchewan, they were all very similar. The other provinces, only the lowest tax bracket was it possible for ERDTOH to be more valuable than the CDA. It depends a bit on your province. When we went through the same exercise using the NRDTOH, or NRDTOH, it corresponded to about $48,000 of non-eligible dividends before gross up for Ontario. In other provinces, it was even lower. In many of them, CDA was always more valuable than RDTOH.
There are some exceptions, but the bottom line is this on the CDA. If there’s a CDA balance, it represents a lot of after-tax value, because there’s no tax liability on it. That erodes quickly due to inflation, because it’s priced in nominal dollars at very low tax brackets, releasing ERDTOH, or maybe even NRDTOH depending on your province. Maybe slightly better at more moderate consumption levels, requiring higher levels of income drawn from the corporation. Or if you’re planning to move a lot of large amount of money out of the corporation, because that would be bumping yourself up tax brackets pretty quickly, then the CDA would probably be the first place to look, because you’re going to avoid that problem completely.
[0:27:40] BF: Yeah, definitely. Even if there’s no CDA balance in there, if you have to take a large amount of money out, realizing a gain to create CDA can be interesting planning.
[0:27:47] MS: Yeah. I call that capital gain harvesting. You can do that without even missing market time. If you buy it, or if you sell it, crystallize the gain and then immediately rebuy it, you can then stay in the market, use some money from somewhere else in your corporation to pay out that capital dividend after you file the election. Ninja move.
[0:28:03] BF: That’s a big-time ninja move. On to ERDTOH, which is the next most valuable notional account, or in some cases, as Mark just described, it can be more valuable than CDA. Generally speaking, it would come after CDA in the rankings. It’s very common to be generating ERDTOH every year from corporate investments. ERDTOH is the 38% refundable tax collected when the corporation receives eligible dividend income.
If you own Canadian stocks in your corporation that are paying eligible dividends, you’re going to have ERDTOH. It also gets refunded at a rate of 38% when you pay out a dividend of the same size as the one originally received. Your corporation gets a dollar of GRIP for each dollar of eligible dividend income received, allowing the eligible dividends to be paid out to shareholders to release the associated ERDTOH. As an example, to put some numbers on that, if your corporation gets a $100 eligible dividend, it’s going to pay $38 in part four corporate tax. But it gets that $38 back when it pays out a $100 eligible dividend to a shareholder.
After personal tax on the eligible dividend, you would have $61 of personal buying power. With a $38 refund, the net corporate tax would be zero, because fully refundable part four tax. Like with the CDA, the personal buying power of that $100 eligible dividend and the value of that $38 refund to the corporation is going to erode with inflation over time. Now, while not quite as dramatic as the savings and erosion with the capital dividend account, it is still pretty substantial.
[0:29:30] MS: Yeah. Another way to look at it is that the RDTOH, that refundable tax, it’s basically like an interest-free loan to the government. They’ve collected that money in advance, they’re not going to pay you interest for having that money stored. By not releasing it, there’s an opportunity cost on those dollars. You’ve given it to the government and you’re not investing it yourself. Now the trade-off is that if you have to pay some personal tax to access it, then that’s going to be factored into getting that money back, or calling that loan back it. When you need to pay yourself money to live on using a dividend to release the RDTOH, or to get that interest-free loan repaid back to your corporation so that you can invest it, it makes obvious sense.
Now in the case of a dividend beyond what is needed for your consumption, you have to prepay some personal tax by taking the dividend out early to get that corporate money refunded. That’s a different question than just taking dividends out to fund your consumption and get the refund. That’s a no-brainer. But if you are going to think about the refund, “I want to get that refund back. How much is the cost to do that?” That’s a more complicated question we’re going to come back to.
[0:30:34] BF: We spent some time figuring that out in preparation for this episode Some time.
[0:30:39] MS: Yeah. A lot of time and there was brain healing time on top of that.
[0:30:43] BF: That modelling that we did on that really highlights the opportunity cost aspect of it, because we looked at this as pay out of personal dividend and then invest the RDTOH refund. I think if you don’t incorporate that piece, which captures the opportunity cost, then the answer would be materially different.
Okay, onto the NRDTOH. Part of what makes the erosion of unused GRIP in ERDTOH from eligible dividend income substantial is the fact that eligible dividends are more tax efficient at the personal tax level than non-eligible ones. Still, the non-eligible RDTOH, or NRDTOH, as Mark calls it, I don’t usually call it that.
[0:31:17] MS: That was a discovery doing this podcast and I just love it.
[0:31:20] BF: It is very funny. You don’t call the ERDTOH, ERDTO. There’s a mismatch there. The non-eligible RDTOH, or NRDTOH that gets collected from interest foreign dividends and the taxable half of capital gains does still have value. Not as much as ERDTOH and CDA, but still some value. The amount collected is going to vary by income type. For example, 30.67% of interest income, or the taxable half of capital gains goes to NRDTOH. For foreign dividends, as we talked about in a past episode, it’s functionally less due to the interaction with foreign tax credits. We covered that back in episode 10. That one’s super messy, but interesting interaction there.
The NRDTOH is going to accrue more slowly likely than the ERDTOH does for eligible dividends, but it’s refunded at the same rate of 38% of the dividends paid out of the corporation. Now, importantly, only non-eligible dividends can release non-eligible RDTOH. That was something that a relatively recent budget fixed, because there was a bit of an arbitrage there previously, because non-eligible dividends are taxed at a higher personal rate than eligible ones. The buying power that NRDTOH represents is going to be less.
Now similar to ERDTOH, there is an opportunity cost aspect to this thinking, but in this case, the immediate cost of releasing the RDTOH, the NRDTOH is going to be higher due to the higher personal tax owing on the non-eligible dividends required to release it.
[0:32:42] MS: Let’s just take a quick pause there to recap and put the bottom line together, because thinking in terms of personal buying power, corporate refunds, adjusting for inflation, that’s all pretty mind-bending. Then if you add in the fact there’s current and future tax rates, it’s mind-breaking. We can come up with some good general approaches to prioritizing the notional account usage. That’s actually pretty straightforward simple and is going to be right in the vast majority of the time.
In the current tax year, the most efficient source of income is usually capital dividends using the CDA, because it’s tax-free. That can sometimes be displaced by ERDTOH at low personal tax rates, when the personal tax is low and the refunded RDTOH to the corporation makes the combination a bit better. That can happen at low personal tax rates at moderate to high income levels, which again, we’re going to have that if we’re driving higher levels of consumption. Under capital dividends, the next most efficient way to pay yourself is eligible dividends. That’s due to the release of the ERDTOH refund, along with lower tax rate on eligible dividends compared to regular ones.
This represents if you were to compare that difference is about a 9%-10% tax savings compared to non-eligible dividends, depending on your province. Plus, there’s also the refund of 38% to the corporation on top of that. That’s the next most important one. Then the lowest priority is non-eligible dividends, which clear out the NRDTOH, and that releases the NRDTOH refund, which would otherwise be eroding in real terms. But it’s less tax-efficient from a personal tax point than using an eligible dividend. That’s what puts it down a little bit lower.
[0:34:18] BF: To reiterate the reiteration, because this is complicated stuff, when we’re prioritizing emptying out the notional accounts, the CDA would be first, through a capital dividend. Then the ERDTOH and GRIP through eligible dividends. Then the NRDTOH through non-eligible dividends. Following that order is going to maximize tax deferral in the corporation and minimize the erosion of the value of the notional accounts. With the 20% erosion due to inflation we discussed in the examples to fund the same level of personal consumption, the corporation would be down an extra 18% for unused CDA, 10% for unused ERDTOH and the GRIP that came with it and 6% for unused NRDTOH. The inflation clock is ticking for you to empty out your notional accounts with the same priority of CDA ERDTOH and NRDTOH.
Now, there is still a situation where notional accounts that we haven’t discussed, there’s still a situation with notional accounts that we haven’t covered yet. Leftover GRIP without any unreleased ERDTOH.
The corporation can get GRIP two ways, if you remember from the previous episode. From eligible dividends that it receives, like what we just talked about with receiving dividends from shares of a Canadian company that you own your corporation, and from active income that was taxed at the general corporate tax rate. If you have active income in your corporation above the small business deduction limit, then you end up paying tax at a higher rate and you end up with GRIP with no associated ERDTOH.
Paying the eligible dividends to clear out the GRIP generated by eligible dividends received is very favourable, because it also gets the ERDTOH refund. That’s pretty sweet. If you have GRIP with no associated ERDTOH from active income tax at the general rate, the value of that residual GRIP is going to be less. Limited to the savings that you get personally for using eligible dividends instead of non-eligible ones. That personal savings runs in the 9%-10% range depending on the province and tax bracket. Keep in mind that this is taking advantage of taxes that your corporation has already paid.
[0:36:07] MS: Yeah. If you need the money, using more eligible dividends to clear out that GRIP usually makes good sense. If it’s not used, the value is going to erode over time with inflation. However, because it’s a smaller savings compared to those other notional accounts, it erodes much more slowly. Just using that 20% erosion from inflation that we used previously, the corporation have to pay out an extra 3% or so to get the same buying power as if it used the GRIP went right away. It’s relative terms, it’s not a big deal. It’s such a small difference that it also means that it could sometimes make sense to you salary instead, even though there’s some GRIP that’s left there.
I’ll just give you a quick example of that when that could happen. If you have some GRIP left and you need to still fund some consumption, but you also have a spouse that you could pay a salary to that’s in a low tax bracket, if they’re in a lower tax bracket and they’re not able to income split using dividends, because they get caught up with the TOSI rules, then it could change things.
If you can dividend split, you could just give both partners eligible dividends, empty out the GRIP and be super-duper tax efficient. But if this is a low-income spouse who can’t receive a dividends, then the salary that you pay them could be at a lower marginal tax rate for that income than even the eligible dividends would be at the higher tax rate, higher tax bracket for the high-income active shareholder. That could happen if there’s a corporation with a lot of passive income requiring a lot of dividends to clear out the RDTOH accounts, but you still have some GRIP left over.
For example, if I had a corporation with $100,000 of eligible dividend income from investments, plus $100,000 of active income that was taxed at the general corporate tax rate, that would make for $100,000 of GRIP from those investments, because it’s a dollar-for-dollar addition to my GRIP account. Then for the active income that was taxed at that general corporate tax rate, which in Ontario is close to 27%, it’s a fair bit higher, 72% of that gets added to the GRIP. $72,000 of GRIP from that active income. That gives me a total of $172,000 of GRIP.
If I need money to live on, I could pay out $100 in eligible dividends. That releases the RDRDTOH, but I also have a spouse who can do $40,000 of work for the corporation and has no other income. If I still need money, I could pay myself an eligible dividend at the net tax rate in Ontario, which that tax brackets around 25%, when you consider the dividend, tax and the enhanced credit that comes with it, or I could pay my spouse a salary at a 20% marginal rate, because they’re $40,000. We’d pay less tax in the current tax year by giving my spouse a salary and leaving that GRIP, rather than using it and taking it out at a higher tax rate in the higher income spouse’s hands.
[0:38:50] BF: Another exception here is GRIP with no SBD, with no small business deduction. If a corporation has no access to the SBD at all whatsoever, meaning that all net income creates more GRIP, you have a choice between paying eligible dividends, reducing current GRIP, or paying salary, reducing new GRIP by reducing your active income. If you pay dividends just to use the existing GRIP, the corporation’s net active income just generates more GRIP. It’s this ongoing feedback loop. If you use salary, that’s a corporate expense and decreases the corporate active income, subjected to the general corporate tax rate. We also know salary is favoured by integration and it creates RRSP room, which can get more money out of the GRIP feedback loop by paying additional salary to max out the RRSP.
With salary providing better tax integration, plus the advantages of RRSP, or IPP contributions, using salary instead of trying to empty the GRIP would win this battle out. We modelled this to make sure it made sense, because there are a lot of moving parts here. We ran a case with 2 million dollars in a corporation, $350,000 of net active income, and $15,500 of monthly after-tax personal spending. We modelled the RRSP being maxed out each year based on the previous year’s salary and we looked at four different compensation strategies; dividends only, salary only, and two strategies that run through the notional accounts. One of these algorithmic strategies prioritizes GRIP over salary and the other, salary over GRIP. We measured the outcomes based on the final after-tax net worth and maximum spending with a high success rate.
We held the success rate of spending to 95% and did Monte Carlo simulation to find maximum spending. We found the best strategy on both measures was the one that empties out all notional accounts and then prioritizes salary over GRIP. Again, that was specific to the case where there is GRIP, but no small business limit. I’ve seen that happen at least when there are multiple large business would be an example, or when there are multiple people working through one corporation.
[0:40:52] MS: Yeah, and there’s also in Quebec, there’s some special rules that make it hard to access the small business deduction, too. There are lots of ways it can actually happen. This is something you can encounter. Now the other question is, is there a time where you might want to pay extra dividends to invest that personally? This is different than what we’ve been talking about. We’ve been talking about taking out dividends to release notional accounts to fund consumption. But there may be cases when paying dividends, even when you don’t need the money to spend right now could make sense.
Now, when we talk about this, we’re assuming that you’ve included funding your tax-sheltered accounts and your personal debt repayment as part of your consumption plan. If there’s unreleased notional account money paying dividends to fund TFSAs, or RRSPs, or pay down debts while getting that refund, or the tax reductions from using your CDA, or RDTOH, or your GRIP, it usually makes sense, because you’re going to get all those advantages, plus you’re putting the money into something that’s tax sheltered, or going to grow without grow tax-free, essentially.
It’s shifting money from a tax-exposed corporate account into a tax shelter of some type. What we’re talking now is a bit different. We’re talking about going to take excess money out of the corporation to clear out some of those notional accounts. Dividends to release some RDTOH, for example, and then investing it personally in a regular taxable account. Since you don’t need that money right now, you can invest it. The situation where you’re generating notional account balances faster than you clear them out by paying dividends could happen actually in a number of situations. Common ones are if you have a lot of household income from outside the corporation, I’ve seen this. You have a spouse who’s not incorporated, makes a great income. It’s enough to pay for your cost of living, well, what do you do with your corporate money? You can choose how to take that out.
Another one would be, if you have a low spending rate relative to the corporate income. A lot of corporate income, not a lot of spending. If you’re deferring a lot of income in the corporation by income splitting with a spouse, you may be able to live on taking less out now. Your household tax bill is minuscule, but you’re growing this large passive corporate income machine. You’re going to start getting RDTOH and the question is, should you be starting to move some of that money out by paying dividends, some tax and getting the refund?
[0:43:00] BF: Whether it’s going to make sense to pay an extra dividend is going to depend on too many variables, I think, for us to give general rule of thumb advice as with many of the things we’re talking about in this episode. For example, it’s going to depend heavily on your personal tax rate on the dividend. Your ongoing personal tax rate for personal investment income. What you’re doing with the funds, are you investing or paying off debt? What your future consumption plans are? What your tax rate will be when assets in the corporation are eventually drawn out? A lot of moving parts.
Now, the ultimate answer here is going to be it depends, but we’ll try and walk through some examples to hopefully build some intuition. With the CDA, it actually is pretty straightforward. There’s no personal tax in the CDA and the cost of losing it to inflation is so high that the capital dividend should typically be paid out, as long as the accounting fees are not too high relative to the dividend. Those funds can then be used for whatever personal use is unrelated to direct consumption. It could be paying down debt. It could be maxing out registered accounts. It could be investing in personal taxable accounts. It’s highly likely to make you better off in any case than having left the CDA balance just sitting in the corporation.
[0:44:03] MS: Now that with the refundable dividend tax on hand, or the RDTOH, it’s different. It’s a more of a maybe not answer. Paying extra dividends just to release RDTOH is generally less obvious than the capital dividend. RDTOH requires paying a taxable dividend to the shareholder. The benefit on the refund side needs to be greater than the personal taxes. In the current tax year, the corporate refund of 30% may be greater than the personal tax cost on the dividend. Most commonly when using eligible dividends with their lower personal tax rates, that’s going to have the best chance.
However, that 38 refund that the corporation gets when you pay out that personal dividends still actually has a tax liability that’s baked into it. That 38% gets refunded at the corporation, that still has to make its way out eventually and personal tax paid to get it from the corporation into your personal hands. At its core, the dilemma is a tension between corporate tax deferral benefits versus lower tax drag on personal investments, and how efficient it is to make that lane change from the corporation to the personal accounts now versus the future.
To put that another way, the variables that affect whether it makes sense to pay extra dividends to release the ERDTOH and invest the excess personally will include your current and your expected future personal tax rate, and the difference in after-tax expected returns between the corporation investing and the shareholder investing. Those are the big ones. We made a model to examine the relative impact of those variables to see which ones are more important. It was mind bending, but we came up with a few key takeaways with some practical planning implications doing that.
[0:45:43] BF: Yeah. Before we get into the big planning factors, one factor that impacts how big the personal tax rate is versus the alternative of delaying the RT2H refund is whether the personal dividend required is eligible, or non-eligible. The corporate refund of 38.33% of the personal dividend paid is the same in both cases. But to release the NRDTOH requires a non-eligible dividend and personal tax rates on non-eligible dividends are close to the ERDTOH refund in top tax brackets, or even drastically lower at the lower personal tax brackets.
Then in contrast, personal tax rates on non-eligible dividends are higher and exceed the corporate refund in more mid-range tax brackets. The threshold, the pay-out extra eligible dividends to release ERDTOH is much more liberal than it is for releasing the NRDTOH. It’s also going to vary a bit by province. Provinces with high personal tax rates will have a higher threshold to pay extra dividends, versus leaving the money in the corporation.
[0:46:40] MS: Yeah. This really comes to one of the big important things is what the long-term personal tax rate trajectory is. One of the most important factors in considering whether to pay out extra dividends just to release that RDTOH depends on what your longer-term trajectory is, where you’re going to end up and eventually have to take the money out at. A lower personal tax rate today means less of a tax hit on the corporate dividend. It also means a higher personal after-tax rate of return on the investments, so you’re paying less tax drag on your personal investments each year now, so your rate of return, net of tax is going to be better when you’re in a low personal tax bracket, more so than a corporation usually, if you’re in this trapping situation of the RDTOH.
Now in contrast, at a lower tax rate in the future means keeping more invest in the corporation, instead of taking it, and that benefits more from corporate tax deferral. Paying a dividend to release the RDTOH left that refund invested in the corporation, but it still meant paying more money out of the corporation to release it. Recall that tax deferral works best when you’re deferring from a high current to a low future tax rate. That’s where you get that arbitrage there.
Now there are some ways that long-term trajectories is obvious. For example, if you cannot in a dividend split with your spouse now, but you will be able to dividend split with them later, that could dramatically lower your future personal tax rate. Waiting a few years and then releasing the RDTOH down the road at that drastically lower tax rate may make sense. Now on the other hand, if future income splitting won’t drop your tax rate, and there’s lots of reasons why that could happen, then there is a serious question of whether your future tax rate to get the money out of the corporation is actually going to be higher than your current tax rate.
If the reason why you have a surplus of RDTOH is a one-off event, you realize a massive capital gain, then your future tax rate may be similar. You could move the RDTOH surplus out slowly over a number of years. However, if the reason why your RDTOH is building up in your corporation is that your current corporate investment income, it just keeps growing and growing with your portfolio, then that’s just going to continue to get worse over time if you’re not getting money out of it.
[0:48:52] BF: It’s going to keep getting worse, because unreleased RDTOH in that scenario, that’s growing corporate passive income exceeding personal consumption. It’s not consumed. The corporate money eventually comes out when you die, unless you donate everything to charity. That will likely translate to the top personal tax rates in the future. If your future tax rate is higher than taxing the tax hit now, taking the tax hit now at a lower tax rate may be better mathematically, and tax deferrals working against you, in that case. From a utility standpoint, this problem also represents an opportunity to consider adjusting your consumption upwards to better smooth it over your lifespan, using your giving money while you’re alive rather than when you’re dead. Giving with a warm hand, rather than a cold one.
We just talked about the cost of moving money out of the corporation now versus in the future. The other big variable in this decision to pay these extra dividends is if you’re considering paying out extra dividends to release trapped RDTOH and invest personally, you have to really worry about what your personal tax rate is going to be. What’s the personal tax drag on the way? Remember, tax drag is the loss of growth each year that you have from paying taxes on the investment income from dividends interest and the taxable half of realized capital gains. When we discussed corporate investment tax drag in absence 10 and 11, we mentioned that it’s very efficient when the RDTOH is flowing out due to dividends paid to fund personal consumption close to the lowest personal tax bracket.
However, when the RDTOH is trapped, like we’re talking about here, corporate tax drag becomes seriously worse. Dramatically worse. Because there’s that upfront tax close to the top personal tax rate and then no refund released in the corporation to offset the high corporate tax paid on investment income.
[0:50:29] MS: It’s trapped in there and it’s not released until you actually pay the taxes out, and the value of that erodes with time. In our modelling, when we assume that you use the same asset allocation personally and corporately, because that mix of interest in eligible dividends and foreign dividends could change how tax efficient things were. We kept it the same amongst all accounts. We know that with the foreign dividends, it’s a little bit less tax efficient. But it can vary between the corporation and how you’re investing personally and that varies by the income type, it varies by the tax bracket.
We did find that the income mix makes a minor difference, the personal tax bracket makes a big difference. Tax integration of investment income generally favours personal investing, and at the top, personal marginal rates is very close to a corporation with RDTOH trap. Except with foreign dividends, which are much less efficient in a corporation for the form of holding tax reasons that we mentioned in episode 10.
However, as you move to lower personal tax brackets, the tax drag favours personal investing much more substantially, because that corporate tax taxation is based close to the top marginal tax rates. As you get into low personal tax rates, your personal tax rates are actually better. I would also point out that the other investment for your overall net worth to grow is to also remember to pay off debt. If you have extra money that’s coming out, interest payments that you save by paying off debt have no tax drag associated with. You don’t get taxed on the fact that you’ve saved your interest payments.
There’s some practical implications of the tax drag influence on the extra dividend dilemma that we’ve just been talking about. If either you, or a lower income spouse are in a mid to low tax bracket, then that favour is taking some extra dividends and investing them at a low personal tax rate. The RDTOH refund can be reinvested within the corporation, or also paid out. It depends on when you want to do that, depending on how much it bumps you up in tax brackets.
[0:52:21] BF: The other thing that we’ve found in our modelling that matters is time frame. The lower tax drag of personal investing can even make up for favourable corporate tax deferral if the time frame is long enough. That’s a balance between how much of an advantage a lower future tax rate, like from income splitting over age 65 gives, versus how much faster the personally invested money is going to grow, just due to the higher after-tax growth rate. The longer that time frame is, the more it’s going to favour taking the money personally now to be invested at a lower personal level of tax drag relative to the corporation.
We modelled out to 40 years in the work that we did on this. That may seem like a long time, but remember that you’re investing horizon lasts until you die, not just until you retire. If you have a low current and high future tax bracket, then shifting money out of the corporation is always going to win. Even with a short time frame, if your future tax rate will drop, then how far away that drop is and how low your personal investment tax drag is influences the ultimate outcome. We’ll explore that more in the case conference episode for this. But this is really an example where using some financial projections into the future and tax planning in the current year meld together.
Okay, so that leaves us with the last item here, which is what to do with GRIP when you don’t need extra dividends right now. We’ve been talking about this idea of paying yourself additional dividends that you don’t need to spend to invest personally. We talked about the cases where that can make sense, when you have ERDTOH, NRDTOH. Now we’re talking about that last case of GRIP, where there’s no RDTOH to release.
When you consider the issues that we just talked about, with RDTOH and that GRIP is a less valuable notional account with the inflation adjusted buying power eroding very slowly, it would be pretty unusual for it to make sense to pay out extra eligible dividends that you don’t need. The one case is maybe you’re from a very low tax bracket, or if you face losing non-refundable tax credits, which is something that we’ll circle back to later.
[0:54:15] MS: Yeah. I think the debate of how and when to clear out trapped RDTOH and GRIP is a really good example of how some planning and strategy can make a big difference. You need to be able to make a projection of what your future income and consumption will look like, and then make adjustments along the way. The reason why I say you have to make adjustments along the way is because future projections are not going to be perfect, which is why you’ll make some adjustments, because some of the assumptions may change over time.
Still, if you have some adjustments over time and a proactive planning plan, that’s probably going to put you into a better place than just realizing that you’ve got a problem later and when you’ve got a massive corporation, a bunch of trapped RDTOH, and then now you’re also looking at it, taking it out in a high personal tax rate to get it out. You’re much better off planning that out in advance, seeing what you can take out over time and making more of a life cycle approach to how your corporation compensation is going to work.
Now, the best way to do that is very situation specific and it changes with your goals about consumption over your lifetime, your estate planning. If you’re going to be doing a lot of charitable giving with your estate, that changes the situation as well. I will say, that my wife and I’ve actually done this type of planning. Not only did our combined personal and corporate tax bills dropped, I mentioned that at the beginning of the episode, but importantly, from a utility standpoint, we also feel more comfortable spending and giving a bit more now in the present than we would have otherwise.
We have natural tightwad tendencies, so spending is difficult. We can put a reference there to the Rational Reminder episode on tightwads. We fit that bill. To spend actually does take practice and effort if it’s not part of your natural tendency, and it will say that the reassurance of having a robustly model financial plan helped us out with doing that.
[0:56:01] BF: Yeah, it makes sense. You’re either going to spend now on things that you want to, or you’re going to pay it in taxes later.
[0:56:08] MS: Easy choice for me.
[0:56:09] BF: I think it’s probably an easy choice for most people, yeah.
[0:56:12] MS: But only if you realize it. Only if you realize that’s the issue. Most people don’t realize that’s the issue. It’s a someday issue.
[0:56:18] BF: That’s the key. People don’t realize that’s what’s happening, then it’s the way you said makes sense. That would be a motivation to spend on things that you care about, knowing that you’re otherwise going to pay it to higher tax rates later.
[0:56:28] MS: Still tough. We have these conversations pretty often in our house.
[0:56:31] BF: The other item to cover here is the CCB, the Canada Child Benefit clawback versus Notional Account Release. We’re still on this topic of paying additional dividends to release RDTOH, or other notional accounts to invest personally, so taking income that you don’t need. The CCB is going to be there for kids under age 17 that qualify for the Canada Child Benefit.
If you’re eligible for the Canada Child Benefit, it gets clawed back using the taxable income of your household, not of an individual. Both partners, if they have income. The amount of CCB is around $7,500 per child under $6,000 and $6,000 per child aged six to 16. It’s a tax-free benefit and is really intended to help low-income households. It does start to get clawed back at household incomes over $33,000 and then more rapidly for incomes past $71,000, again, at the household level.
The rate of clawback also increases with the more kids you have. The clawback ranges from about 3% to 4$, to 23%, depending on the number of kids and income level that we’re talking about with the highest clawback rates happening pretty early. It is complicated, CCB clawback. But it’s also possible for families with the right combination of kids and income level to still collect some CCB, even with household incomes into the $200,000 a year range. Losing the tax-free benefit is functionally like an additive tax rate increase.
Now importantly, dividends are grossed up to determine the taxable income and the clawback for CCB. That means that eligible dividends are multiplied by 1.38 and non-eligible by 1.15, for the purpose of calculating your household income, for the purpose of calculating your CCB clawback. Taking dividends accelerates the clawback rate compared to the same amount of salary. However, a lower dollar amount of dividends are required to fund the same amount of after-tax consumption, because they also come with a tax credit. There is some funky interaction going on there, too.
[0:58:28] MS: Yeah, that’s a very important point. We actually have really had to model this out to see what was happening. Step one in planning your compensation mix is targeting it to your consumption. All of the possible scenarios with CCB are beyond what we can cover in today’s episode. However, we did model the impact of paying dividends to release notional account balances, versus losing money to the clawback. We did that in a bunch of different ways. Overall, the order of the notional account usage was unchanged. Capital dividends don’t cause any clawback, because the CDA’s value is not taxable and it erodes quickly with inflation if it’s not used.
Now, if there is going to be CCB clawback, that gives the CDA a bit more of an edge against using dividends to release RDTOH. We talked about some of those really low-income situations where ERDTOH may take priority over the CDA. That disappeared when you started to have CCB clawbacks coming into the situation. Except maybe at incomes in the bottom one, sometimes two-tax brackets, depending on the province. But it does make a big difference there.
Now, most of the time that we’re paying dividends to empty notional accounts, it’s actually to fund consumption. I think this is important. In that situation, we’re using it to fund consumption. The alternative to taking those dividends and getting the RDTOH refund is using salary. Now, salary is not grossed up, so there’s less CCB clawback. However, the increased corporate tax deferral from the dividends, plus the erosion of the value of the notional accounts by inflation, that actually all overpowers the effect of the clawback from the difference of how much salary and tax there is, versus how much dividends and then dividend and tax there is. That was underpowered compared to those other factors.
We looked at kids that were one to four kids, ranging from either being all under six, to all the way up to being teenagers. That was interesting to get showed. There’s interplay that’s there about how bad the clawback is now, versus how badly the notional account erodes before the kids age out of CCB at age 17. The longer the time to aging out, meaning younger kids, means more erosion of that unused notional account by inflation. It actually made it worse. Slightly higher inflation rate makes it worse quickly to leave those notional accounts unused.
Both of those factors favoured using notional accounts sooner rather than later to fund consumptions. That’s important. If you’re using it to fund consumption, it’s going to be useful. If you’re taking out extra dividends just to invest, then that changes the situation, because you’re taking extra dividends to release that notional account and invest personally, but that CCB clawback has a pretty big adverse effect in that situation. How badly depends on those factors I just mentioned about inflation exposure. It doesn’t kill it completely, but you need to be able to invest the excess money at a really low personal tax rate to make it worthwhile, or have the future corporate tax rate rise to overcome relative to what your current tax rate is, which if you’re spending very little money now and you are going to have a really large corporation, that could enter into the thinking pattern.
I think it’s important to put this issue of CCB clawback into perspective. While it can happen, if you’re paying dividends to live off, the only way to reduce the clawback really is to spend less. That’s an extra challenge. It’s really challenging when you have kids in the mix to reduce your consumption. The other point I’d make is that notional accounts come from having passive income in the corporation. If you’re facing dilemmas about whether to pay extra dividends or not, it means that you have a large corporate passive income, and that you have low personal spending. That’s why you have that problem. If you have that problem, that’s an easy problem to fix by spending a bit more. It would also be pretty uncommon to have that problem for someone earlier in their careers.
Early in your career, you probably don’t have as much money invested in your corporation spitting out that passive income, you’re spending money to live on. That’s often the time when kids are in the mix as well. Most young professionals will have small notional accounts requiring a few dividends to empty and this isn’t going to be a big issue. Most of their income is actually going to come out of salary and they have to take that out to pay for their costs of living anyway.
[1:02:35] BF: Exactly. For people with not a whole lot of corporate investment income, it doesn’t take much in dividends to keep those notional accounts cleared out. People that are early on in their saving trajectory won’t have too much to worry about there. There usually still be a personal cash shortfall to meet your personal spending and saving targets though. Even when you’re just starting out with your corporation, you might have more expenses, like kids, like you’re just mentioning, Mark.
To make up that shortfall is then going to be a choice between salary, or dividends. Without the extra benefit, the extra value that you get from releasing notional accounts. Salary has a bunch of advantages, actually, that we talked about in episode 12. Our view on this and our modelling bares this out, is that salary should generally be the first choice once notional accounts have been considered, as we discussed in the previous sections.
[1:03:22] MS: The other thing to think about when you’re paying yourself salary is factoring in the RRSP contributions to be able to take advantage of them. When you’re determining how much salary is required to give you the after-tax money that you need to spend, you also have to account, there’s going to be some taxes owed on that salary, plus will be a Canada Pension Plan contributions, which isn’t really a tax. It’s going into your pension for the future. We’re going to talk about that in the next episode.
One of the advantages of the salary though, is it also creates this RRSP room. RRSP contribution room. You probably want to use that RRSP contribution room. You’ve paid salary and paid the taxes to generate it. You want to take advantage of the tax sheltering that comes with it. You get the income deduction and then you can invest that money for tax-sheltered growth.
When you’re talking about paying yourself salary, you have to factor in some extra salary that’s required to be able to put into that RRSP contribution room that you’ve created. For example, if I needed $100,000 of salary to get the after-tax money required to live on, then I would actually probably pay myself $118,000. That way, I’d have $100,000 to live on and I’d have that extra $18,000, which I put into my RRSP. There would be no tax on that extra $18,000, since it’s deducted against income and I make that RRSP contribution. I used a $100,000 for that example and that’s over the yearly maximal pensionable earnings for CPP contributions.
If I am paying out extra salary for RRSP contributions at lower income levels, I still would also need to factor in a little bit extra on top of that for those Canada pension plan contributions. Again, we’ll talk more about that in an upcoming episode. The other wrinkle for factoring in some extra salary to put into your RRSP is that if you exceed the RRSP maximum contribution limit, then once you’ve reached that point and you need more salary to fund your consumption, then the math gets easier again, because you don’t have to worry about factoring in some extra contributions into your RRSP.
For example, after a taxable income of $175,000 in 2024, adding more salary is not going to generate more RRSP room beyond the $31,560 maximum. At that point, you just need to figure out how much salary you need to live on, count for the tax, and then that’s what you’d want to pay yourself.
[1:05:37] BF: I want to make sure something’s clear for listeners, which is that we’re talking about taking additional salary to fund RRSP contribution room, being created by salary that you took a fund consumption. What our modelling has also shown is that taking – because this one comes up a lot. Taking salary for the sole purpose of creating RRSP room. Taking salary that you would not otherwise spend for the sole purpose of creating RRSP room probably does not make sense. This is in the cascading order of priority, salaries coming after clearing out all of the notional accounts and you’re taking enough salary, although there are some exceptions to this one too, I think. You’re taking enough salary to fund your consumption after tax and then additional amount to fund your RRSP room that is created by the salary that you took to fund your consumption. We’re not talking about taking salary that you didn’t need in order to create RRSP room.
[1:06:24] MS: The way that I thought about this that changed my way of thinking about it, because I used to struggle with this one a lot, but I think the way of thinking about it that eventually made it make sense to me is that because if you think about the money you’re putting in the RRSP, well, it’s a dollar for dollar deduction against your income, you think, “Okay. Well, that’s great. It’s just going to be tax-free, 100% pre-tax money.” But if you don’t need that money to live on, you’re actually taking out $100,000 of money to get $18,000 room. Actually, it’s only 18% of it that’s pre-tax money. You’re going to pay tax now on that other 82% of the money that’s coming out that you otherwise would not have been paying, so you’ve lost a lot of tax deferral in the corporation just to get that salary now to get that 18% of contribution room. That small amount of contribution room is way overpowered by the loss of corporate tax deferral. That’s the way that I’ve mentally think about that to understand why that happens.
[1:07:16] BF: It’s a good model for thinking about why it looks the way that it does. I know that one comes up a lot. I looked at this years ago on, should you max out RRSP room that you already have? The answer there is pretty obvious. But should you create RRSP room, taking salary that you don’t actually need? The answer there is less obvious. But our answer is no, you should clear out notional accounts and then take as much salary as is needed to fund consumption once notional accounts have been cleared out.
[1:07:41] MS: That’s a really important point, though, because our people that I know, they’ve already paid the salary, they’ve already taken the tax hit to create that RRSP contribution room, and they haven’t used it. It’s just sitting there unused, which if you think about it, if you’re just to take money from your corporation and put it into that RRSP, there’s no tax on that movement, and it moves it from the corporation to a tax shelter. Whatever reason, some people still have this contribution room that’s not used, which turns out to be suboptimal.
The only time I could think about that being useful is if you’re expecting some big income bump in the very near future. Like, you’re going to have a pension pay-out from commuting it, or you’re going to sell some personal real estate and get a big capital gains tax bill in one year, and then you’re going to use that RRSP room in the very near future. Otherwise, if you have unused RRSP room, you’ve already taken the tax hit to get it, so you should be using it.
[1:08:31] BF: That’s another big one. That’s almost CDA-level public service announcement. If you have RRSP room, you should be using it.
[1:08:38] MS: Yes.
[1:08:39] BF: Okay. Let’s talk about factoring in income splitting using salary. One of the best ways to income split with a lower income family member is to pay them a salary for some work that they’ve actually done for the corporation. Now, the main limiter there is that you can only pay them a market salary for the work that they’ve done. You can pay them a higher end salary, but still it has to be market based.
Still, with all the advantages of salary, it would be preferable to using dividends even if you can dividend split. Now just to be clear, when I say that I’m assuming that you have already paid out enough dividends to clear your notional accounts, that comes before salary. That’s in our order of operations, notional accounts first. If you can dividend split, then splitting dividends to equalize the tax link of both partners makes that even better, clearing out the notional accounts even better. Now I’m talking about salary to make up for extra cash flow needed after dividends have been used to clear out all the notional accounts.
As we mentioned earlier, in this segment about leftover GRIP from active income, sometimes paying a spouse with a lower marginal tax rate than the high-income spouses, eligible dividend tax rate could take priority over clearing all of the GRIP. That would be a pretty uncommon scenario. The most common scenario would be clearing the notional accounts and then paying the rest of the required income out using salary.
Depending on incomes from outside the corporation, that could be more to one spouse than the other, the goal there being to equalize their personal tax flow incomes. Of course, if the lower income spouse has a low income outside of the corporation and does minimal work for the corporation, the market rate for that work is going to be usually the limiting factor. Then the more active spouses have to pay a higher salary to make up for the cash flow needs. Now, still redirecting some income toward a low-income spouse can reduce the personal tax bill and how much total compensation the corporation is required to reach the personal after-tax cash flow target.
[1:10:26] MS: I’m going to give a quick example just to illustrate how that works and how I work through that if I was looking at this problem on my own for myself. Let’s say, that my Ontario corporation has $10,000 of eligible dividend net income, it has $20,000 of interest income, and I can’t dividend split. I would plan to pay out $10,000 of eligible dividends and $16,000 of non-eligible dividends to clear out my ERDTOH and my NRDTOH respectively. That’s what came from that passive income. With the dividend tax credits, there would be very little tax on that. Now if my lifestyle spending is $100,000 and we have no income outside of the corporation, then I would still require another $72,000 or so after-tax money to fund my lifestyle.
Now, if my spouse does $20,000 worth of work for the corporation, then I could pay them a $20,000 salary. That wouldn’t be enough to equalize our taxable incomes, but it is the most that I could pay them for the work that they’ve been doing. After tax, we’d still need another $50,000 or so cash flow to fund our lifestyle. I could then pay myself enough salary to make up that difference. About $103,000 of salary to account for the taxes, the RRSP and CPP contributions, while leaving enough money left after that to spend our funding needs.
Just to put that together, my compensation would be a $10,000 eligible dividend, a $16,000 non-eligible dividend, and $103,000 of salary. I would contribute $18,500 to my RRSP, $4,000 of my salary would have gone to the Canada Pension Plan. My spouse would get $20,000 of salary, contribute $3,600 to their RRSP and $1,000 going to the Canada Pension Plan. In total, we would have paid a little under $22,000 in personal tax to fund our lifestyle.
Now, if I did not pay my spouse that $20,000 salary, then I would have to pay myself $130,000 of salary. That would also mean I’d put an extra $5,000 into my RRSP to use that room that I’ve now created. I would also have to pay $29,000 in taxes. If you put that together, income splitting using some salary would have saved our household $7,000 in tax. The tax bill without income splitting would have been a little bit more than that even, but with my spouse having no income disposal tax credit, you reduce some of the taxes owing. I did factor that in when I was giving that example.
What the spousal amount is, it’s basically unused personal amount from a low-income spouse, you can move that over to the other spouse. It’s for a very low income, under about $16,000 federally with some variability by the provinces. But the point is very low personal tax rates can occur in some situations. Those may also be the rare occasions when paying some extra salary, even if you don’t need it, could make sense which we’ll touch on next.
[1:13:23] BF: Yeah. I want to just recap our steps so far. We’ve got the consumption plan. We’ve got the mandatory income that you have from whatever sources, then clearing out the notional accounts, you’re figuring out what you need to spend, figuring out how much income you have no control over that’s coming in, then clearing out the notional accounts with dividends. We spent a lot of time talking about that. Then taking salary to make up the difference, including enough to max out your RRSP. Now the step throughout here is, I mentioned there’s an exception to taking salary that you don’t need. Step five is salary that you won’t actually take for spending. There are some cases where it can make sense to take some salary, even if you don’t need to spend the money. One of those cases is when your personal tax rate is less than the corporate tax rate. If you don’t need much money from your corporation and also have little other taxable income, then it is possible that the corporate tax rate is higher than the personal marginal rate.
That’s almost impossible when looking at the SBD rates, because the SBD rates are all lower than the lowest personal tax rate. The only situation here is really, if you lived on less than the basic personal amount, maybe if you forage in the bush for food, or something like that. I’ve known people to do that, actually. They spend very little and there’s a whole – this is totally off topic. There’s a whole culture of people that dumpster dive behind grocery stores for groceries.
[1:14:34] MS: I have quite a few family members that would have forage in the bush for food, mushrooms, fit little heads and other stuff you can get. There are actually some neat things you can do.
[1:14:43] BF: In that case, your personal consumption could be very low, if you’re getting your food from urban, or actual forest foraging. In general, the general corporate tax rate in most provinces is higher than the personal tax rate for incomes, the exception there being Alberta, where the corporate tax rate is lower than the lowest personal tax rate. Outside of Alberta, there are plausible scenarios where you may take unneeded salary from the corporation. Unneeded, meaning you don’t need it for personal consumption. For example, if you had a corporation tax at the general rate and your spouse made enough money to cover your cost of living, then taking a $55,000 salary from the corporation could make sense.
However, if your corporation invests its retained earnings, there would probably be a lot of them in that case, then the dividends required to keep the RDTOH flowing would likely eat up the lowest tax brackets pretty quickly.
[1:15:27] MS: Yeah. I think that would happen very fast. I only thought of this situation, because I’ve actually encountered it with someone. Their practice was part of a big group that had to share all their small business deductions, so everything was taxed at the general corporate tax rate. Corporate income was at high tax rate. Their spouse made enough money to cover their costs of living. What they decided to do with their corporation, they actually, at that point, were just sitting on a bunch of uninvested corporate cash. The biggest answer that I had to their question was about salary was actually that they should probably look at whether they should be investing their corporate cash pile, rather than just letting it sit there.
However, they should also be considering whether to pay themselves some salary and investing that, too, at least until the corporate passive income grows enough that you’re paying dividends out to keep that RDTOH flowing, which may not take very long if you have a large enough income and you’re investing that.
The other situation, which we mentioned briefly earlier, that you might want to take a little bit of extra salary is if it means that by not taking it, you’re going to lose some non-refundable tax credits. This could happen at a super low income, like the personal exemption level, which mentioned which was extremely low. But more commonly, it could happen if you’re using just dividends to pay yourself. This could happen. The dividend tax credit is a non-refundable tax credit. You use it, or you lose it.
With the enhanced credit, if you’re just paying yourself eligible dividends to live on and you’re able to dividend split, maybe you’re after the age of 65, or you meet the criteria, you could pay your household around $110,000 a year in some provinces like BC, or New Brunswick, Ontario, or Saskatchewan, without fully using up that non-refundable dividend tax credit that came out with the dividend that you got. Below that, you’d actually be leaving some of those unused tax credits on the table. It could happen.
One of the ways to make sure you don’t lose that is make sure you take some money out. That’s going to be taxed and then use up those tax credits, so that could be done to salary, or could be done by taking out some extra dividends to a point where you’re now your net tax bill is actually zero and it’s not negative with that negative part actually being lost, because you don’t get the tax credits. The other solution to that, of course, is to spend a bit more. Solve the issue.
[1:17:38] BF: In the case of taking money out where you didn’t need it for tax reasons, it’s related to what you just said, Mark. But the question is what to do with that cash? I think at this point, it’s like, thinking back to your values and what your big picture goals are and ways to spend that we talked about in the first four episodes on designing a good life. How could you realign how to spend some of your time, or your money. Now, if you have personal debt, then paying, repaying that can help both financially and psychologically.
If you have unused registered account room, that’s relatively easy one. Sheltering money to invest there is generally going to make sense. If your adult children have debt, or if they have unused TFSA, FHSA, RESP, or RDSP room, then funding that and using it as an opportunity to teach someone about investing, that passes on not only money, but the skills to manage it. Giving effectively and tax efficiently to charity is also a skill. That changes when you start dealing with larger dollar amounts. You could use excess cash while alive to not only develop that skill, but also, hopefully, and likely enjoy the process.
Just was back with the comment I made earlier where this is a case where you were either going to pay it in taxes, or spend it. Though, it’s an opportunity to think about things that you could spend it on that aligns with your values.
All right, let’s talk about bonusing down to the SBD rate. This is another common thing that we hear about. How you invest excess personal cash is related to this same topic. One of the big salaries that often comes up among professionals is this concept of bonusing down. That’s the idea of paying yourself a salary bonus to bring the corporate active income down below the general rate to the SBD rate. For example, if my corporation’s net income is $550,000, paying $50,000 to bring the net corporate income down to $500,000 and avoiding some tax, the higher general corporate tax rate and the 27% range on average. We know the tax integration favours salary, versus corporate tax, plus dividends, particularly at the general corporate tax rate.
The idea here is even if you don’t need the personal income, it can make sense to bonus down out of that higher general corporate tax rate. If you did need the money to live, or if you had our RRSP room to fill up, you would be taking that money out anyway, so it’s a non-issue. With bonusing down, we’re talking about taking extra money now to avoid the general corporate tax rates and the imperfect integration issues downstream. Then investing that extra money in a personal non-registered account instead of in the corporation.
[1:19:54] MS: Yeah. It’s interesting. It sounds like a compelling idea and it’s often brought up. Bonusing down is often a suboptimal strategy in many cases. In preparation for today, we did make a simple model to illustrate why, because it still comes up and it’s actually not intuitive, at least it wasn’t for me. There are a few issues that interact with each other. Using money to bonus down means no corporate tax because of the deduction, but full tax at your personal tax rate instead.
For example, at $250,000 in Ontario would be 53.53% personal tax now to avoid that 26.5% corporate tax rate. That’s a much higher personal tax rate. That’s a big loss of corporate tax deferral by doing that. Now, the other factor is the extra growth on that starting capital is hard to beat, unless the annual tax grade drag on growth in the corporation is much, much higher than personally. If you deferred tax, you have a bigger lump of money in your corporation to invest, you would have to be pretty inefficiently invested to make up for that loss of the tax deferral.
Now, if the corporation has trapped RDTOH making it inefficient, paying some dividends would resolve that issue, probably more efficiently than bonusing down. We’re not talking about that situation. The RDTOH refund, if you had that available, would make it a better option. That’s why it’s higher up in our hierarchy of decision making. This is the last area for us to even consider thinking about at other issues tax rates. If you defer from a high tax rate now to a lower tax rate in the future, that makes keeping that money in the corporation even more beneficial. That works against bonusing down.
Bonusing down with a high personal tax rate now when you have a lower expected future tax rate would be a pretty clearly detrimental thing to do. Now, an obvious way that it could happen is if you’re spending a lot now and you can’t dividend split, but in retirement you spend less, or the same even, but you can dividend split so your tax rate is going to drop, which means waiting to do that is going to be the right answer.
[1:21:54] BF: The opposite could also happen. If you can bonus down at a lower personal tax rate now, it’s more attractive than leaving money that has to come out of a high tax rate in the future. Again, that is the issue of spending very little now, growing a massive corporation and then having money forced out later at high tax rates. Smoothing consumption over your lifespan addresses that.
[1:22:14] MS: Yeah. The other thing is that the type of investment income in the corporation can also have some minor impacts on that. When I set up our model to look at this, I used a globally diversified 80% stock, 20% bond portfolio, and we used a 20-year test horizon. We used future returns and inflation from the 2023 FPC Canada guidelines. We’ve talked about those before and we’ll put those assumption projections in the footnotes. If we use the same current and future taxable income, then bonus down for incomes under $100,000 in Ontario favoured using that bonus down strategy in terms of after-tax, inflation adjusted dollars over that 20-year timeframe.
Now I would say, there’s two important caveats to that. One is that the $100,000 that I’m talking about, that includes the bonus. If my baseline taxable income were $55,000, I could give a $45,000 bonus. That would give me up to that $100,000. If my corporate income was $545,000 before that bonus, that would bring it down and eliminate income that’s taxed at that general corporate tax rate. We’re still talking pretty low personal income tax levels, and some limits to how this could be beneficial.
This would be an unusual situation, where I have a corporation taxed at the general rate and I require very little money to live on. Now if that were the case, I would be building a large corporation that may also run into some of those other issues we talked about from too much passive income, like RDTOH trapping, or the passive income limit, shrinking the small business deduction. That’s one caveat.
The other caveat that I’d say is that the advantage was very small. It’s a very slight advantage. Like, in this model is 2.7% more after-tax money at 20 years. That’s a minuscule advantage that could easily vanish in the future if the future unfolds in different ways that we haven’t predicted and deviates from our model. It also disappears if you have kids in the picture. We talked about that Canada Child Benefit clawback earlier in the episode. If that’s going to affect you, that makes that minuscule advantage disappear completely.
Another way to look at this is the balance of the cost of unfavourable tax integration versus the tax deferral advantage. Jamie Golombek did a nice analysis of this previously, which we put into the footnotes of this, so you can link to that to have a look at it. Really, the way of looking at that way is the number of years that it takes for the tax cost upfront from imperfect integration to be outstripped by the corporate tax deferral advantage. If you look at it this way in our model, it was just over three years at the top Ontario tax rate, Jamie Golombek found that to be very similar at the general corporate tax rate. I think in his model it was four years, set of threes. But he also had a different mix of income in there.
Instantly, he also looked at the small business deduct rate bonusing down at that. As you can imagine, that’s not going to be very favourable, since the small business deduction rate for a corporation is just so good. Anyways, with that analysis, it was pretty close. The type of investment income can make a small difference, like I mentioned. We had that 80-20 portfolio. In that analysis, they had a 5% year of taxable income coming into the corporation. With us, with that 80-20 portfolio is going to be less than that.
Still, one thing that we did do that I think was different from what was presented in that analysis, which was really, I think, pretty good for illustrating the concept is we also test our model at lower personal income levels below the top marginal tax rate. For example, in Ontario with our model, it took 5 years for that corporate tax deferral to catch up at an income level of $125,000 personally. If you looked at 20-year period and you had an income less than $100,000, it actually never caught up. Bonusing down in that situation actually was advantage right out to 20 years. At lower tax brackets, the advantage of bonusing down can become bigger, just because you have such a low personal tax rate.
The time for corporate tax deferral to pull ahead compared to bonusing down is also longer in some provinces, where tax integration is worse. In addition to Ontario, we ran the model in other places. Just to give a good example of that, in Newfoundland there’s an 8% corporate tax cost due to their inefficient integration. The general corporate tax rate and then flowing money through it as eligible dividends is not nearly as efficient. In that case, it took 19 years for corporate tax deferral to catch up, compared to bonusing down, or not at all if you bonus down for incomes under $150,000, which is still pretty substantial income. It depends on the province.
There’s also the other end of the spectrum, too, like BC has very tight tax integration and the corporate tax deferral there comes out ahead a little over one year. It’s very quick, because the tax cost from the imperfect integration is very low, and then you have all that tax deferral in the corporation which is beneficial.
[1:27:04] BF: Those centres were using the same income during accumulation and de-accumulation. The impact of current BC’s future income tax rates also makes a major difference. I know that’s not a big surprise, because that’s how tax deferral works. The best situation for a corporation and fortunately, a common one is deferring tax to keep money in the corporation now during high earning years, than paying tax on a lower rate during retirement when you not only have a lower income, but you also have the ability to income split with a spouse easily.
[1:27:31] MS: The common and a good situation. We did also run the same model with future income half the current income, just to see what that looked like. Doing that, it was really hard to find situations where bonusing down and losing that tax deferral from the corporation could possibly come out ahead, because moving down to a lower future tax rate was just so powerful with that corporate tax deferral.
It could be possible with really low incomes under $55,000, but we’ve already talked about that earlier that the tax rates there are probably lower than the general corporate tax rate anyways for a lot of places. If you pay low, or moderate tax now, grow a massive corporation, there were some plausible cases for keeping it in the corporation, rather than bonusing it down was detrimental over the 20-year horizon. That’s getting to the opposite thing, where if you go from a low to a high future tax rate, it makes tax deferral less advantageous. That raises the bar of how much income you could bonus down to a little bit higher. Sometimes it could come out into the $100,000-$150,000 range if you’re going to have a worse personal tax rate to take that money out in the future. All of those variables work together. The most common situation would be that it probably does not help you out.
Now, I would say the important point of this game comes back to this idea of you to make a financial plan modelling your future spending to know whether this is helpful or not. You have to be able to have that plan, so you can smooth your consumption over your lifespan and without modelling of some type, it’s pretty hard to do that.
[1:28:57] BF: I love the bonusing down analysis, because it is a common thing that comes up. One of those counterintuitive ones where people think it makes obvious sense and then when you actually dig into it, it’s not as obvious. Start wrapping this up here. An important takeaway from our overall discussion is the importance of long-term thinking. That’s come up multiple times as we’ve gone through these various points. Maximizing tax deferral in the corporation is not always optimal and finding ways to efficiently get money out of the corporation will tend to be beneficial. One of the best ways to do this is by shifting income into accounts, like an RRSP, or possibly an IPP. Those options require a history of salary to create space, which creates some interesting interactions with taking salary.
As income strategy that prioritizes salary first would maximize the lifetime room in an RRSP, or IPP, but potentially result in notional account inefficiencies. That’s again, more interesting interactions. At the other end of the spectrum, a dividend-only strategy would result in more tax deferral in the corporation by using tax-efficient capital dividends and eligible dividends while also keeping the RDTOH flowing, but it would preclude the use of an RRSP, or IPP. We’ve got an income strategy that prioritizes salary first. You get all this tax-deferred, tax-efficient room, but you end up with notional account inefficiencies, or an all-dividend strategy, you end up with flowing RDTOH, but no RRSP, or IPP room and no CPP as well.
The income strategies that we’ve been talking about through the compensation planning steps in this episode is what we call a dynamic salary strategy. You’re not taking all dividend, or all salary, you’re using discretion each year following the steps that we’ve talked about. Following the steps results in a roughly, approximately optimal combination of tax deferral, notional account efficiency and salary with RRSP contributions to make up the remaining gap in income needs.
I laugh at roughly approximately optimal, because even through making this episode, we’ve adjusted the algorithm for the withdrawal order and done little tweaks and optimizations and it’s gotten better, so maybe there are other ideas that we’re missing. I don’t think we are, but the algorithm is imperfect, not to mention the future being unknown.
[1:31:06] MS: The big message is though, or what makes the big difference, some of the tweaking we did was minor differences.
[1:31:12] BF: With the dynamic salary strategy, the mix of salary and dividends is going to change over time as a corporation’s passive income grows. That approach should see a shift from salary early on, when there are minimal notional accounts to progressively more dividends, with potentially lumpy differences over time, when things like realizing a capital gain happen and there’s a capital dividend account available. Now, how long that shift from salary to dividends takes depends on corporate active income, passive income, personal consumption.
To finish off on this topic, we want to talk through how this strategy might unfold over time with a couple of examples of analysis we’ve done. We did a big analysis project at PWL, which as it turned out, we were unwittingly doing in parallel with Mark. I think I sent you the stuff we were working on, Mark, and you were like, “No way. I’ve been doing the same thing.”
[1:31:59] MS: Yeah.
[1:32:00] BF: We basically built a comprehensive financial planning model that captures all of the corporate nuances we’ve discussed in this episode, and then we built an algorithm that walks through the steps similar to what we discussed in this episode that optimize where money’s coming from. We only looked at Ontario in our analysis and that has the tax integration anomaly that favours exceeding the passive income limits, as long as you’re spending enough to use up the GRIP that it creates.
We looked at cases with no salary at all, all dividends, with a constant high salary set to maximize RRSP room and a dynamic salary similar to what we described in this episode. We evaluated the long-term outcomes on after-tax wealth and maximum sustainable retirement spending. Our model also included an IPP and that was one of the things that we spent a lot of time getting into that model, because they’re pretty complex in terms of how the room works and how the money can come out later. The IPP is a defined benefit pension plan that an incorporated business owner can set up, even if there’s just one person, so it’s an individual pension plan. Its rules are very different from an RRSP. Functionally, it’s similar.
Conceptually, it’s similar in that it requires past salary to build room, contributions are tax deductible, growth is not taxed, and eventual withdrawals are taxable as income. Different rules, contribution limits are generally quite a bit higher with the IPP, but conceptually, it’s a similar idea. We included variable returns in our analysis and that gave us some additional interesting results and insights. We did a bunch of simulations based on different return outcomes. The main findings of that paper were that a dividends-only compensation strategy is never optimal in the case of that we looked at. A maximum salary strategy was optimal in cases that prioritized spending and a dynamic salary strategy was optimal in cases with lower spending relative to assets. We also showed that taking capital dividends out as they become available meaningfully improves long-term outcomes.
[1:33:49] MS: That was a great paper, and I ran similar type of simulations with my own model, not thousands and thousands of Monte Carlo simulations like Ben’s team and I just use constant returns, but the bottom line is that the message was basically the same. In my case, I used a low cost DIY RRSP investing strategy, rather than an IPP, but the message was the same that a dynamic strategy to use dividends for emptying your notional accounts and some salary to make up the remaining gap is what came out ahead.
Now in my analysis, I also looked at other provinces in addition to Ontario, and Ontario does have that anomaly which can make going over the passive income limits actually beneficial, rather than punitive. When I look at this in other provinces, we’ll talk more about this actually in our next episode about the Canada Pension Plan using that salary and dynamic with dividend approach actually is even more beneficial in provinces outside of Ontario, New Brunswick. They get the bad things get attenuated. Whereas, in other provinces, getting a lot of passive income in the corporation has a bigger penalty associated with that.
There are some ways that you can manipulate things around to try to have dividends only come ahead. Perhaps, if you just used a eligible dividend and capital gains only strategy, but of course, if you tried to do that, yeah, you’re going to get some tax efficiency, but you’re going to have really concentrated other risks instead. Same thing if you try to use corporate class ETFs to just have capital gains, which as we’ve mentioned, they flow through really efficiently using dividends and capital dividends. But again, you’re taking other risks with those corporate class ETFs that make them a little bit different.
I think we’ve covered off most of the big issues. I think the one other thing I would say about a few words, try to use a dividend-only strategy in Ontario and New Brunswick, it can squeak out ahead sometimes potentially, but you’re leaving all your eggs in that corporate basket and you’re also relying on that tax anomaly never change, which over a longer period of time, I think that’s probably pretty doubtful.
If you use a dynamic strategy of salary and dividends, like we’ve talked about today, you’re also going to have an RRSP and probably be using your TFSA, maybe even a personal non-registered account. When you go to draw down that money in retirement, having those options gives you money more options to plan for your spending, which may not just be smooth. It may have big splurges here and there and having some after-tax, or lightly-taxed money can make a big difference for you.
[1:36:11] BF: Yeah. I think that’s such a strong additional argument for the dynamic salary concept. We know that we can model it as being measurably optimal when we look at things like, ending net worth and spending amounts and stuff like that, but the much harder to model idea of tax treatment diversification, I think is a really strong additional argument. It’s not even needed to justify the dynamic spending, but as a bonus, I think that’s a really nice thing to add on there.
The long-range plan that we were just talking about is really tough. In this episode, we focused on optimal compensation using a mix of salary and different types of dividends. That’s practically done a few years at a time in blocks of time, because we can only think so far in the future. We can only predict what our lives are going to be like so far ahead in the future, but it is also important to take that longer-range view of the planning, thinking about your lifetime consumption. A corporation can be used to shift income for usage in retirement, but it should be part of a larger plan that also uses other accounts, like the RRSP, or maybe an IPP, and what will impact those, plus other pension, or pension-like options for people with corporations in another episode. For now, we’ll just debrief to recap the main message from today’s episode.
[1:37:19] BF: Yeah. Just for our post-op debrief, for those people that are still left with us here after all of that mind-bending analysis. We talked about an optimal compensation strategy plan to pay yourself from your corporation. You should make that plan in collaboration with your tax advisor. I’d have made that salary in dividend optimizer calculator that’s on looniedoctor.ca, that runs the algorithm that we’ve just described today in the back. Now, you still have to be able to input a bunch of different things, like your notional accounts and what your plan for spending is, but it could help with playing around with some of the ideas and guiding some of the discussion.
Regardless, understanding the main considerations around using salary and dividends is vital for you to provide your advisors with the relevant information and to be able to ask the right questions about possible strategies when you’re planning how to compensate yourself. For example, you can’t plan your compensation without considering your consumption plan for the coming year. Probably even the next few coming years if you want to use some income smoothing in there. How much you need to pay out of your corporation each year will depend on the gap left between your consumption plan and how much money that you already get from your personal income, so employment, or personal investment income, you receive and pay tax on that. You don’t control it, but you can control how the money comes out of your corporation.
[1:38:37] BF: In deciding how to pay money at your corporation, you would want to look at using the corporate notional accounts as soon as possible. You can find out your notional account balances from your corporate tax filing, or from your accountant. You should also consider what will happen to them with anticipated investment income. You release the power of notional accounts by using dividends. That will likely be very few dividends in early career, because the most important accounts, like CDA and RDTOH accrue due to passive investment income. If you don’t have much investment income, it won’t be as much of an issue.
As your corporation generates more passive income, you’ll need to pay out more dividends to keep the money flowing out of those notional accounts as efficiently as possible. There is a bit of a clock ticking, because the notional accounts attract the nominal dollars, so their buying power that they represent erodes with inflation over time. The priority of dividends to maximize corporate tax deferral and minimize the loss to inflation are usually capital dividends first and then eligible dividends to empty the ERDTOH followed by non-eligible dividends to empty the NRDTOH. That’s the most common. But at the very low personal tax rate, sometimes the RDTOH may take priority if the corporate net income refund is significantly more than the personal taxes paid. Even the general rules all have little exceptions that we’ve talked about in lots of detail throughout the episode.
It’s possible to have some GRIP left over from active corporate income tax at the general corporate rate. If you need the money, then emptying that using eligible dividends comes next with the possible exceptions of a low-income spouse who can only be paid a salary, or a corporation that has no access to the SBD.
[1:40:08] MS: Yeah. If you don’t need the cash, but you have a large CDA balance, you may still want to consider using that before it erodes in value. It’s much less clear whether to use excess eligible, or regular dividends just to empty the RDTOH, which we talked about in detail, if you don’t need the money and you’re going to invest it personally. The ultimate outcome with that really depends on the relative tax drag of personal versus corporate investing and at what rate you eventually would take money out of the corporation at. Of course, the timeframe matters for that, too.
That type of dilemma of getting trapped RDTOH, or GRIP may be a good indication that it’s actually, you should revisit and plan how you spend and invest and donate over your lifespan, because that’s why you’re having that problem.
[1:40:50] BF: You’re not spending enough. You’re either going to pay it in taxes, or figure out a way to spend on things that you care about. Most people starting out will not need large dividends to clear out the notional accounts. They need money to spend, and most of that is efficiently paid using salary early on. Plus, salary allows better tax deferral and sheltering in a corporation when the RRSP, or IPP room that gets generated is used, it’s an opportunity to shovel money out of your corporation into a tax-sheltered environment over the long run using a dynamic strategy of dividends to empty notional accounts with enough salary to make up shortfalls and use an RRSP, or IPP is usually the optimal way to fund consumption through a corporation from the modelling that we’ve done on this.
The salary and dividend mix may and likely will shift over time, and it will also likely be punctuated by one-off events, like capital gains if you realize a gain, or if you want to splurge on something like, I don’t know, a carbon fibre, or maybe a titanium bike.
[1:41:50] MS: Yeah, those are definitely big purchases that require some financial planning. Think of this episode overall as a great example of how financial planning requires a meshing of your tax plan, your investment plan, and your consumption plan together. There’s all these little nuances. But understanding the basics and the big take-home messages from today will help you out. That’s whether you’re trying to plan this on your own, or if you’re participating alongside your advisors to come out with an optimal plan for your situation, you have to understand all of these different variables to at least some basic degree to have a good conversation about it. With that, we’ll finish this episode off.
