Should I do dividends or Salaries as an Owner of my Company.
I often get the question of “should I do dividends or salaries” and I strongly believe that salaries are better than dividends, which is contrary to what everyone else says. When I advise clients that they should do salaries they will often ignore my advise on the matter and go with dividends regardless. Today’s posting I will address every argument ever conceived for the “dividend” camp and debunk the myths. Then through a combination of addressing these arguments and providing you with the advantages of doing salaries I hope to be able to convince you that salaries are better than dividends.
Myth #1 – I pay less taxes doing dividends.
You do not pay less taxes. In theory you pay about the same amount of taxes. While it true that CPP currently costs about $5500 a year per person for the owner’s salaries, that CPP contribution is not a tax. It is a CPP – Canada Pension Plan – contribution. In other words you are contributing to YOUR own pension through Canada’s national pension program. You are not paying an extra $5,500 in taxes. It is fundamentally no different than paying an extra $5,500 into your RRSP’s for your own retirement. So you are not paying more taxes, in fact in the calculation of corporate taxes and personal taxes, there’s generally an integration. This integration is the concept that it shouldn’t matter whether you pay yourself dividends or salaries, tax laws are designed so you pay the same amount of taxes, and in real life, some years you get an edge on salaries, and other years you get an edge on dividends… that edge in either scenarios is usually never very big difference to worry about. The main focus really is this $5,500 amount that is going to CPP. If you can accept my notion that a CPP contribution is not a tax payment, then you can agree that you don’t pay more taxes.
Myth #2 – I would do better investing my own $5,500 amount every year than letting the government do it.
Everyone says this and the truth is nobody actually puts aside an extra $5,500 amount and invests it on their own. Everyone says they will but I’ve seen enough business owners to know that this simply doesn’t happen. If anything consider this… CPP is an pension plan, and a pension plan is essentially a type of investment vehicle. One concept of good investing is diversification. You invest a little bit in high tech, maybe a bit in utilities, maybe in banks, maybe in real estate and etc…. Well why wouldn’t you invest a little bit in CPP? After all, not only is it an investment vehicle, the CPP investment board is able to make investments that you cannot. For example, large public projects like toll bridges or highways that you can’t buy. If you believe in diversification then you should believe in investing and contributing in the CPP.
Myth #3 – Okay but maybe the CPP won’t be around when I retire.
Everything in the universe is impermanent. Eventually everything will not be around. Does that mean the CPP won’t be around when you retire and need it? That depends on your outlook on the government and your country. Here’s my take on it… If CPP isn’t around then likely neither are those investments that you hold in an open stock portfolio. The CPP is so large and scaled up compared to each of our individual portfolios, that if the CPP goes bankrupt then I’d bet money there’s a good chance that many of the companies on the TSX are likely gone too. So yes the possibility of CPP not being around is real but it is about the same odds as the country in general going to hell. If you don’t believe those are good odds, and if you think Canada will be around when you’re 65… well then you should probably invest in the CPP. Think of it this way, every employee everywhere in the country is contributing to the CPP, so there’s a continuous stream of cash flows going into it, it’s not going to go bankrupt.
Myth #4 – Perhaps they’ll be around but I don’t trust the government with my money.
Back in 1997, there was this huge thing about CPP maybe going under especially because at the time the Federal government is not separate from CPP. Such that in theory, although it didn’t happen a whole lot in practice, the Federal government could dip their hand into the CPP funds. As of post 1997, that just isn’t the case anymore. CPP is completely separate from the Federal government, in fact by law they must give your contribution money to CPP and not keep any of it. Could they change this rule? Maybe. Would they though? It’s political suicide. We can’t contemplate on what if scenarios, and the fact and matter is at this time the Federal government cannot touch CPP funds. Just as likely in the future they could change the rules on dividends (and they have been for a few years now) to make it deliberately disadvantaged to receive dividends.
Myth #5 – Okay sure it’ll be around but I don’t need it for retirement because it’s too small to care about.
Today if you maxed out your CPP over the course of your career and you turned 65, then your maximum payout is roughly $1200 a month or about $14K a year. Your annual contribution is roughly $5500 so let’s say over 30 years that’s $165K of contributions. Regardless of whether you need it for retirement, that’s $1200 a month that you get to the day you die. Do not worry about inflation because the CPP is inflation adjusted. Don’t treat the CPP as a component of your “needed” funds for retirement but simply a component of strategic planning. If you treat it as a strategic component then you’ll see that after 12 years of receiving the CPP you’re at the point of break even as an investment. If you live past that point, you’re getting more money than you contributed. These are rough numbers of course and please don’t hold me accountable for that. I am giving you illustration of simplicity only. If you don’t need the money for retirement that’s great for you but think of it as buying yourself a retirement safety net … or rather… insurance. If you’re part of that fortunate group that doesn’t need it, you then of all people should do it as part of insuring against the future and it costs you very little to do it.
Okay… I get it about CPP… but you haven’t given me any reasons why I should do salaries!!
Here’s some advantages of salaries other than the CPP which I think is a good thing:
Salary Advantages #1 – RRSP’s
Salaries are more than just the CPP contribution. They also come with it the concept of working income. You may know about RRSP contributions. These contributions are you putting aside savings for your own retirement – Registered Retirement Savings Plan. The amount you are allowed to put into this RRSP for your own retirement is formula driven at 18% of the salaries you received in the year. Dividends do not generate RRSP contribution limit. In other words, if you did dividends for a long time you’ll find yourself not only having no CPP, but also no RRSP’s of any meaningful amount. The combination of the two factors will significantly hinder your ability for retirement savings. So dividends are bad for retirement planning.
Salary Advantages #2 – Tax Credits and Deductions Planning
Just like how you generate RRSP deduction limits with salaries, more benefits are also triggered by salaries. Those include the following additional tax credits just for having a salary:
a) Childcare expenses – are deductible against salaries
b) Employment Amount – $1200 tax credit just for having a T4
c) Moving expenses – are deductible against salaries only
d) Donations – are only optimal being used against salaries
e) CPP credit – Of course you don’t pay taxes on the contribution monies, you get a tax credit for it!
As you can see there’s a whole plethora of deductions and credits available to you when you pay yourself a salary instead of dividends. There’s actually a couple more very substantial ones that I’m not listing out here because they’re a little more complicated.
If you’re a seasoned dividend receiving owner then you may have noticed that you get a “dividend tax credit” – yes a tax credit for receiving a dividend. AH HA you might say. No it is not an actual advantage of having a dividend. See Myth #1 above on integration. Let me elaborate…
Dividends get this credit to recognize the corporate taxes you have paid already on the money, so not to double tax you when you receive the money personally you are getting this compensating credit for those corporate taxes paid. Combined with the corporate taxes paid, the idea of tax integration is that you have paid the exact same amount of taxes whether it be salaries or dividends. If you had done a salary you don’t pay corporate taxes on that money because it is an expense for the company. Hence the dividend tax credit is not an advantage, it is an illusion.
Salary Advantages #3 – Financial Planning
I’ve advised on the merits of salaries for many years now. One of the byproducts that I’ve observed among my clients that I didn’t realize at the time is the financial planning merits of doing salaries. When you pay yourself a salary, the proportional taxes for that month’s income is due and paid the following month. In other words every month you will be paying the government for a small amount of taxes. Think of it as whatever you owe the entire year divide by 12 is what you will be paying for taxes.
Seasoned dividend receiving owners find themselves in this self described state of being called the “tax treadmill” – I’ve heard that one a lot, it feels like you’re always catching up to pay for taxes every year and that’s because you ARE on a treadmill. Every corporate tax year end you find yourself paying this huge lump sum of corporate taxes. Then at personal tax time in April, you pay yet another huge lump sum amount of personal taxes.
Those clients of mine who have transitioned to salaries have found that as a byproduct they are now managing this tax treadmill a lot better. That’s because for the amount of monies you are paying out each month as a salary, you are immediately paying the taxes on that in the following month. If you pay out a lot of your profits as a salary through out the year, then you have already paid all of your taxes by the end of the corporate tax year. Furthermore, if you keep to your monthly salary as a personal budget, then you may potentially have ZERO taxes to pay at personal tax filing time in April. Wow… Really? Yes! Managing your corporate tax bill all year round, then finding there’s no personal taxes to pay at April are byproducts of doing salaries.
Not to mention, if you’re on this tax treadmill you are also paying probably hundreds if not thousands of dollars in CRA interest every year. Just because you’re doing dividends doesn’t mean you don’t have to pay taxes monthly, the CRA still requires you to pay every month. There is generally interest applied to both your corporate and personal taxes. Doing salaries manages that interest downwards because you’ve been paying through out the year.
I’m convinced that salaries are better for me as an owner – what do I do to get started?
Many business owners, especially the ones who don’t have employees believe that doing salaries is going to be harder than dividends. After all, dividends are easy… you write yourself a cheque for what you need and you worry about the taxes later (see above Advantage #3). So just how difficult is it to start doing salaries?
In the first year of transitioning to salaries, you will find you have already paid yourself a sizable amount of dividends. You are going to start paying it FORWARD now with monthly tax payments, and then at the same time your next corporate tax year end and personal tax year end you still have to pay those large tax payments (albeit maybe smaller) related to the dividends you have already paid. So that first year, it is going to hurt and be very difficult to plan but after that first year you will find you’re in a steady state of financial stability.
Typically the way I help my clients plan a salary is I ask you to first come up with a personal budget. What do you spend on every month? Mortgage? Rent? Car? Groceries? Meals? Things like that… write out a list for yourself on what do you need to spend each month on an after tax basis.
Then I work backwards to gross up your monthly budgeted amount to a before tax amount. I provide you with two payment amounts every month:
- How much to pay yourself – to the penny.
- How much to pay the Government – to the penny.
Then you make those 2 payments every month and that’s it. Not so hard right? At the end of the year, if I’m your accountant I will also file a T4 for you. If you have employees and you already have some kind of payroll provider then you just have to add yourself to the list of employees, so that’s even easier. You don’t have to pay EI, you are exempt as an owner.
Okay I’m on salaries now… but… ?
a) Can I do a combination of salaries and dividends? Yes you can still pay dividends just know that you haven’t paid taxes on that component yet.
b) Can I do just enough for CPP maximization? That amount is approximately $58K in gross salaries.
c) Can I do just enough for RRSP maximization? That amount is approximately $138K in gross salaries.
d) Can I skip a month of salaries because I forgot or don’t have the money this month for it? Yes, but there’s just a 1 minute form you gotta fill to skip a month.
Salaries are better. You get a lot more tax credits and deductions. You get to pay into your CPP which isn’t a bad thing – in fact is a fairly reasonable investment. You get to make RRSP contributions so combine that with CPP you will have a reasonable retirement plan. You get to manage your taxes much better and save on any CRA interests. It’s not hard to put yourself into salaries and it doesn’t really cost anything more.