TFSA for Incorporated Clients
A follow-up to the Question Wednesday in May: Incorporated clients with surplus cash may have received advice against opening a Tax-Free Savings Account (TFSA) account. This week explores why that may be, and what factors go into the TFSA decision.
A quick primer on what some terms mean and how they are used here:
Corporation- for the purposes of this blog, I am referring to privately-held operating companies or investment holding companies. I am focusing on the surplus cash that has been generated by the company/ deposited to the investment holding company from the operating company.
Surplus cash- any money that the corporation owner doesn’t expect to use for at least 3 years.
TFSA- introduced in 2009 by the Federal Government, these accounts allow for deposits, to a yearly maximum amount. Once in the TFSA, the owner can choose how the money is invested. Investment choices are broad, and similar to investment choices within an RSP. TFSAs are owned by a single person; they are not owned by a corporation or jointly with another party. You do not receive a tax credit for your deposits, however, you do not pay income tax on the money when it is withdrawn from a TFSA. When a withdrawal is made, that amount can be re-deposited to the TFSA in the next calendar year. For more information on TFSA rules, see the link below.
Surplus cash in a corporation can be invested for longer-term gains. Investment choices are very broad. Money that stays in the corporation is taxed at the corporate tax rate. Currently, corporate tax rates are lower than personal tax rates, which allows for more money to be invested initially than if the cash were withdrawn from the corporation to be deposited to a TFSA. For example, $1 of earned income inside the corporation may pay 15% income tax, leaving $0.85 that can be invested. If the $1 of earned income is moved out of the corporation to a TFSA, you will need to pay personal income tax on that $1, leaving approximately $0.54* to invest in the TFSA. This initial difference in the amount available to invest is the main driver for the advice to leave the money invested inside the corporation.
I believe that the TFSA option is worth exploring when we start looking at the long-term effects of investments in a corporation and in a TFSA. Investments in a corporation are taxed yearly on the returns that they generate. The returns are taxed as passive income, not as active business income. Investment returns do not receive the 15% corporate tax rate mentioned above; instead they are taxed based on their nature. Interest income is taxed at approximately 50%; dividends at approximately 36%; capital gains at approximately 25%. Investment returns inside a TFSA are not taxed, as the account is tax-sheltered. Over a long time period, tax-sheltering is valuable. The other factors to consider are the uncertainty of personal dividend tax rates in the future- should you choose the ‘invest in the corporation now’ option, when you need the money, you will pay income tax at the going rate. Indications from governments are that tax rates on Canadian Controlled Private Corporations are more likely to move up than down. As the portfolio grows inside the corporation, you are likely to need to re-balance your investments, triggering capital gains. It may make sense to move some of that money to a TFSA, where re-balancing is not a taxable event. See the link below for a paper researched by Jamie Golombek reviewing the nature of investments held and the optimal location. Although the paper was first researched in the brief time that the yearly TFSA limit was $10,000, the conclusions still stand- if you are investing in interest-bearing investments, you are best to move that money out of the corporation and purchase those investments inside a TFSA. Investments that pay dividends are also best inside a TFSA over the long-term. Capital gains (usually generated from stock investments) are more beneficial inside a corporation- it may not be worth the initial tax payment to move the money to a TFSA, then invest.
The decision to deposit to a TFSA or invest inside your corporation is best made in discussion between your accountant and your planner- there are many individual solutions that take into account yearly tax positions and opportunities, as well as investment preferences and overall portfolio allocation. If you don’t have a TFSA solely because of your corporation, I recommend that you review your situation again and see if there are opportunities to tax-shelter while still being tax-efficient.
Disclaimer- the above is a general illustration only, personal circumstances will vary. As always, talk to your accountant before making any significant changes to your situation.
To review your current plan and future goals, please contact firstname.lastname@example.org to book a consultation.
*Individual tax rates can vary depending on other sources and types of income, as well as surtaxes. This number is an approximation of an individual close to the top tax rates.
CRA The Tax-Free Savings Account
An interesting recent comment from CRA on ‘active trading inside a TFSA’