When business owner clients ask if they should contribute to a TFSA (Tax Free Savings Account) or an RRSP (registered Retirement Savings Plan) , my usual response is: “Both!” If you’re a business owner or an owner of a professional corporation, the way you pay yourself has an impact on many different things – including whether it makes more sense to contribute to an RRSP or TFSA.
As an owner-manager, you have three primary choices of how to pay yourself: pay yourself a salary; pay yourself dividends; or leave business income in the corporation. Up to a certain amount, I strongly believe, paying yourself a salary is beneficial. However, that conversation is for another day.
Saving Tax Often Drives Motivation
Tax savings is often the motivating factor in the choice of personal compensation, particularly when talking to your accountant. However, it shouldn’t be the only consideration.
While dividends likely create the lowest personal tax liability, they don’t allow a business owner or the owner of a professional corporation to create contribution room in an RRSP, build up CPP or claim WCB. The form of personal compensation can affect what is received from government programs and credits as well as the ability to qualify for loans from lending institutions.
When you are an owner-manager and you pay yourself only in dividends, there are some distinct benefits that TFSAs offer over RRSPs. Here are three of them.
Benefits of a TFSA over an RRSP when only Receiving Dividends
The first benefit is that to contribute to a TFSA, you don’t need to have any “earned income,” which is typically employment income, self-employment or professional income, or rental income. For owner-managers who pay themselves primarily by way of dividends, TFSA contributions make good sense.
Second, with a TFSA, there’s no maximum age limit to contribute, unlike an RRSP whereby you can only contribute up to, and including, the year in which you turn 71 (unless you have a younger spouse or partner). This makes the TFSA an ideal vehicle to shelter investment income in a TFSA beyond working years. While the cumulative amount of money you can save in your TFSA is lower when compared to an RRSP, each January, new TFSA contribution room becomes available. If you’ve never opened a TFSA before, you can make a considerable contribution in 2022 – $81,500 total (provided you were at least 18 years old in 2009). And, like a dripping tap that overtime can turn into a great flood, each new year of TFSA contribution room will eventually build up to something quite substantial.
Finally, TFSAs are far more flexible than RRSPs as funds can be withdrawn, tax-free, at any time, for any reason, and the withdrawn amount, which includes investment growth, can be recontributed beginning in the following calendar year. With an RRSP, withdrawals that are not made under the Home Buyers Plan or Lifetime Learning Plan are taxable, and funds can’t be recontributed without having new RRSP contribution room.
Tax Bracket Today and in the Future
Taking these factors into consideration, if asked to recommend a TFSA or RRSP, it often comes down to your tax bracket, both today, and in the future, particularly if you don’t have enough funds to maximize contributions to both plans.
If you expect to be in a higher tax bracket when you withdraw funds than you are when you make contributions, TFSAs beat RRSPs for long-term savings. But for many Canadians, who will likely be in a lower tax bracket when retired, RRSPs continue to be the way to go.
It’s Not Either or, But Both
However, for high income earners it’s not a question of which tax-saving vehicle is best. It’s a matter of organizing your cash flow and contributing to both your TFSA and RRSP so financial independence from your business becomes a reality.