Are TFSAs for Canadian Business Owners a good choice?
In BC, to contribute the max amount to a TFSA of six-thousand dollars, your company needs to make more than double! $13,190 to be exact.
Today, we answer whether a TFSA is a good choice for Canadian Business Owners. TFSA being the Tax-Free Savings Account.
We have been given a detailed article courtesy of CIBC who has done all the math for us, and we will be using that today to look at the usefulness of the TFSA for Canadian Business Owners
Let’s get right into it.
What is a TFSA?
So, the TFSA program was introduced in 2009. It’s a way for adults and with a valid social insurance number to set money aside tax-free throughout their lifetime.
Contributions to a TFSA are not deductible for income tax purposes. Any amount contributed as well as any income earned in the account (for example, investment income and capital gains) is generally tax-free, even when it is withdrawn.
Administrative or other fees in relation to a TFSA and any interest on money borrowed to contribute to a TFSA are not tax-deductible.
You can contribute a certain amount every year, this is known as your contribution room.
In 2024 you can contribute $7,000 but in previous years it has been $6,000 and even $10,000 in 2015. Your TFSA contribution room is also cumulative and unused room is carried forward indefinitely.
Like if you have been resident in Canada and at least 18 years old since 2009 and, as of 2022, have not yet contributed to a TFSA, you can immediately contribute $81,500 to a TFSA for example.
Using Corporate Business Income to fund a TFSA Contribution.
TFSA contributions can only be made personally and not by your corporation.
As a result, to make a TFSA contribution using income from your company, you must first withdraw the funds from your corporation.
Suppose you wanted to contribute $6,000 to your TFSA in 2022. The graph on the screen provided by CIBC shows that your corporation would need to earn $13,076 of SBD Income in Ontario in 2022.
After paying corporate tax of $1,595 there would be $11,481 left to be paid to you as a non-eligible dividend. Personal tax of $5,481 would be payable on the dividend leaving $6,000 in your hands for you to make the TFSA contribution.
Alternatively, if your corporation earned $13,457 of General Income in Ontario in 2022, The graph on the screen shows that corporate tax would amount to $3,566 (which is higher than for SBD Income) leaving $9,891 to be paid as an eligible dividend. After paying personal tax of $3,891 (which is lower than for a non-eligible dividend), you would net $6,000 for your TFSA contribution.
The amounts would be different in every province as the taxes of each are different. Here’s a look at the numbers needed for this in the different provinces.
Example of investing in a TFSA or corporation using SBD Income
Let's say your corporation earned $13,076 of SBD Income. As shown in the earlier graph, after paying $1,595 in corporate tax, $11,481 remains in the corporation. You have two options for this after-tax SBD Income:
- Investing in a TFSA: You can withdraw $11,481 from your corporation in 2022 as a non-eligible dividend, pay $5,481 in personal tax, and be left with $6,000 to invest in a TFSA.
or
- Investing in your corporation: You can leave the $11,481 in your corporation in 2022 for corporate investments. When this amount is eventually distributed to you as a non-eligible dividend in the future, you will still pay $5,481 in personal tax (assuming tax rates remain unchanged), leaving you with $6,000.
So, we can see that whether you invest through a TFSA or your corporation, the amount of the original $13,076 of SBD Income that ultimately reaches your hands remains the same after corporate and personal taxes are paid. You would always receive $6,000 (assuming tax rates do not change).
However, there are two key differences between investing through your corporation and via a TFSA:
- Corporate Tax Deferral: With corporate investing, there is a tax deferral of $5,481 since personal tax is deferred until the after-tax SBD Income is ultimately distributed in a future year. As a result, you initially have more to invest in your corporation ($11,481) compared to a TFSA ($6,000). Since your corporation has a higher amount of investment capital, if both corporate investments and a TFSA earn the same pre-tax rate of return, your corporation could generate more investment income than a TFSA.
and
- Taxes on Investment Income: Corporate investment income is taxable, while TFSA income is completely tax-free.
The question then is: Which option is better? Corporate investments, which start with a higher initial amount but generate taxable income, or personal investments, which begin with a lower initial amount but produce non-taxable income?
How your TFSA will grow.
They show us that if you invested a one-time $6,000 contribution in a TFSA at a 5% rate of return, after one year, you would earn $300 ($6,000 x 5%) in investment income. Since all types of income within a TFSA are completely tax-free, the entire $300 would be available to you.
With the graph you’re seeing, if you reinvest this income within the TFSA, after 30 years you would have accumulated a total income of $19,900, in addition to the original capital of $6,000. With no taxes applied, the total investment income in a TFSA will always be $19,900 after 30 years, regardless of the type of income or the province and territory. In this sense, TFSAs can be considered a truly "equal opportunity" investment.
Investing in your corporation.
By leaving the after-tax small business deduction Income in the corporation, you would have $11,481 of capital to invest.
At a 5% rate of return, the corporate investments would yield $574 in income in the first year, regardless of the type of income.
This is 91% more than the $300 of TFSA investment income because 91% more initial capital is available with a corporation ($11,481) compared to a TFSA ($6,000).
The downside is that a corporation must pay tax on its investment income, which reduces the amount available for reinvestment and, consequently, the total amount of investment income that can be accumulated over the years.
At the end of the period, assuming all remaining after-tax investment income in the corporation is distributed as a dividend, you must also pay personal tax on the dividend.
The amount you receive after all corporate and personal taxes have been paid is your “after-tax investment income” from the corporate investments.
Corporate and personal taxes vary for each type of income. Consequently, the net investment income ultimately available through corporate investing varies with the type and taxation of the investment income earned.
Interest
If your corporation earned $574 ($11,481 times 5%) of interest income, after paying corporate tax on the income and personal tax on the non-eligible dividend, you would be left with $241 of after-tax investment income. This is less than the $300 available with a TFSA, as noted earlier.
Over 30 years, corporate taxes would erode the amount available for reinvestment, impacting total investment income. This new graph shows that after 30 years, the after-tax investment income you would receive would be just $10,600, about 47% less than the $19,900 in a TFSA.
In summary, if 5% interest income is earned and 2022 tax rates for Ontario apply, investing in a TFSA is always a better option than corporate investing over a 30-year period.
Canadian Eligible Dividends
Let’s say your corporation invests in Canadian stocks that earn $574 ($11,481 times 5%) of eligible dividends. After paying corporate and personal taxes, the net investment income would be $348, which is more than the $300 available in a TFSA after one year.
The current graph shows that corporate taxes on eligible dividends would impact total investment income to a lesser degree than interest income. After 30 years, the after-tax investment income would be $16,800, about 16% less than the $19,900 in a TFSA.
As we can see, if 5% eligible dividend income is earned and 2022 tax rates for Ontario apply, after-tax investment income would initially be slightly higher with corporate investments than with a TFSA. In the long run, however, starting after about 16 years in this example, the TFSA would outperform corporate investments. Note that the crossover point depends on the rate of return achieved on the underlying investment.
Capital Gains Realized Annually
If your corporation realized $574 ($11,481 times 5%) of capital gains in the first year, corporate and personal taxes would total $166. The after-tax investment income of $408 that you would receive from corporate investing is more than the $300 from a TFSA after one year.
Thankfully we have another graph that shows that after 30 years, the after-tax investment income from corporate investments would be $21,900, which is only slightly more than the $19,900 available from a TFSA.
If 5% capital gains are realized annually and 2022 tax rates for Ontario apply, we can see that over 30 years, corporate investing yields about the same amount of after-tax investment income as a TFSA.
Over the longer term, however, the TFSA would outperform corporate investments. Note that the crossover point depends on the rate of return achieved on the underlying investment.
Deferred Capital Gains
When capital gains are realized annually, corporate tax must also be paid annually, reducing the amount of after-tax investment income available for reinvestment within the corporation. In contrast, when capital gains are deferred, corporate tax is only payable when after-tax corporate investment income is distributed as a dividend at the end of the year(s).
At a 5% rate of return, capital gains would total $574 ($11,481 times 5%) in the first year. If income was distributed at the end of Year 1, the capital gain would be realized, resulting in the same outcome as with annual capital gains: taxes would total $166, leaving $408 with corporate investing.
If the capital gain was not realized annually, our last graph here shows that over time, without annual corporate taxes, the corporation would earn a substantially higher amount of total capital gains. After 30 years, net investment income to the shareholder (after all personal and corporate taxes are paid) would be $27,100, which is 36% higher than the $19,900 from a TFSA.
As we can see, if 5% deferred capital gains are earned and 2022 tax rates for Ontario apply, corporate investing always outperforms a TFSA.
Final Notes
As you can see, many variables can influence your decision to invest in a corporation or a TFSA, but here’s the bottom line: over time, corporate investments will likely leave you with less in your pocket than a TFSA, especially when corporate business income does not benefit from the small business deduction or when investment income is highly taxed.
However, for deferred capital gains, corporate investments consistently yield a greater amount than a TFSA, making them the exception to this rule of thumb. Yet, it's uncommon for investors to defer all capital gains.
If you are a business owner aiming to maximize your investments over the long run and your portfolio includes a mix of interest, eligible dividends, and capital gains, you should consider withdrawing sufficient corporate funds to maximize your TFSA contributions rather than leaving the funds inside the corporation for investment.
Contact Us
At Safe Pacific Financial, we specialize in helping Canadian business owners, incorporated professionals, and investors structure life insurance for maximum wealth protection, tax savings, and business growth.
If you would like to discuss whole life insurance or investments, we’re happy to chat and see if we can be a good fit to work with you. Fill out our contact form and we will get back to you within 24 hours on business days.
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