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tax matters

Sometimes you just have to think radically. That's what William Taylor did. Mr. Taylor is a farmer from Northern Ireland who developed a device called the "Livestock Power Mill" - basically a treadmill for cows. Mr. Taylor figures that the world's 1.3 billion cattle could produce 6 per cent of the world's electricity requirement if the cattle were to walk on his treadmills for eight hours each day. It's radical thinking like this that can make life better for everyone.

Radical thinking might also make life better for you in retirement. I'm talking about setting aside conventional thinking. In particular, I want to talk to those of you who are business owners.

A common approach

If you're a business owner, one of the primary issues that you face regularly is how to compensate yourself. Should you take salary? Dividends from your corporation? Both? A very common approach to compensation is to pay yourself enough salary so that you maximize your RRSP contribution room. After all, your RRSP contribution room is calculated as 18 per cent of your "earned income" from the prior year (salary is earned income, while dividends are not), and is capped at the annual maximum ($22,450 for 2011). If, for example, you had paid yourself $124,722 of salary in 2010, this would entitle you to the maximum RRSP contribution room of $22,450 for 2011. More than likely, you're making an RRSP contribution this month to use up some or all of that RRSP room you've created for yourself.

But does it really make the most sense to pay yourself that much salary and then contribute to your RRSP? Is there a better alternative if you hope to maximize your retirement savings?

A different approach

A recent publication from CIBC Private Wealth Management, "Rethinking RRSPs for Business Owners," builds the case for a different approach to retirement savings. Written by Jamie Golombek, the publication concludes that, as a business owner, you'll be better off paying yourself dividends from your corporation to fund your lifestyle needs, and leaving the excess earnings in your company to grow for retirement. The other alternative, of course, is to pay yourself sufficient salary to maximize your RRSP contributions and save for retirement using your RRSP as the savings vehicle.

Take an example. Suppose you pay yourself $124,722 of salary out of your corporation, contribute the maximum $22,450 to your RRSP, and live off the rest of the after-tax income. In this case, you'll have about $72,000 after taxes to spend. Your RRSP will grow over time. At the end of 20 years, assume the RRSP is liquidated and you keep whatever is left over after tax. Call this Scenario A.

Now, compare this alternative to Scenario B, where you instead draw enough dividends from your corporation to provide you with that same $72,000 after taxes to spend, and you then leave the excess in your corporation to be invested. At the end of 20 years, assume that the portfolio in the company is liquidated and the funds are paid out of the corporation to you personally.

CIBC's figures show that you'd have more in your hands after taxes in Scenario B, and this is true regardless of the portfolio you choose to create in the RRSP or in the corporation (i.e. fully equity, balanced, or fully fixed income).

The reasons

So, why do the numbers work out this way? Three reasons. First, less tax will be paid overall if you allow the company to pay tax on its earnings and then pay dividends to yourself rather than salary. Second, the after-tax amount going into the investment account inside the corporation is higher than the amount being invested in the RRSP each year. Why? Because the personal tax on any salary paid out is more than the corporate tax paid on earnings kept inside the corporation (if we assume the earnings in the company are eligible for the small business deduction; this is generally the case on the first $500,000 of taxable income in the corporation).

Finally, the portfolio inside the corporation is more tax efficient at the time of liquidation than the RRSP because you'll only face tax on capital gains at that time (RRSP withdrawals, on the other hand, are fully taxable as income).

There are other things to consider before making a final decision as to how you're going to save for retirement if you're a business owner. You'd be wise to visit a tax pro to talk it over.