There are several income tax advantaged investment vehicles in Canada, the best known being the Tax Free Savings Account (TFSA) and the Registered Retirement Savings Plan (RRSP).
Using these tools for investing gives you more funds in the future compared to investing without them.
Add the professional corporation to this list.
A TFSA is funded with after tax dollars. There is no tax deduction for contributions to a TFSA, but you also don’t pay any tax on the investment growth and don’t pay tax when you take funds out of the TFSA. There are limits to the amount that you can invest in a TFSA. As of 2013, you can contribute a total of $25,500. The cumulative limit is $5,000 per year for 2009 through 2012, plus $5,500 for 2013.
With an RRSP, like a TFSA, investment growth is not taxed. Unlike a TFSA, you get an income tax deduction when you make contributions and pay income tax when you take funds out. Ideally, you will be in a lower tax bracket when you withdraw the funds compared to when you contributed the funds. The amount you can contribute to an RRSP for 2013 is the lesser of 18% of your earned income and $23,820, plus any unused contribution room from prior years.
I look at a professional corporation as being similar to an RRSP:
- If you are in the highest tax bracket, your taxes are reduced by 44% of your RRSP contribution.
- If you are in the highest tax bracket and leave business income in your company, your total taxes are reduced by 30% of the income left in the company.
- Because you received a full tax deduction for your RRSP contributions, you are taxed on your withdrawals from the RRSP.
- Because you deferred taxes by leaving funds in your professional corporation, you are taxed at a reduced rate when you take funds out of the company as a dividend.
At the most basic level, using an RRSP gives you an immediate tax deduction with the expectation that you are taxed at a lower rate in retirement when you take the funds out. Using your professional corporation gives you an immediate tax reduction with the expectation that you will be in a lower tax bracket when you take dividends out.
There are also some significant differences:
- Investment income in your RRSP is not taxed while funds are left in the RRSP.
- Investment income in your corporation is taxed on an annual basis.
- Any funds withdrawn from your RRSP are treated as regular income. The tax advantaged treatment for dividend income and capital gains is lost when they are earned in an RRSP.
- Funds withdrawn from your company as dividends are taxed at a lower rate to take into account tax paid at the corporate level. In addition, the 50% non-taxable portion of any capital gains can be withdrawn as a tax-free capital dividend.
- RRSPs have a number of restrictions on the type of investments that can be held.
- The only restriction on investing for most BC professional corporations is that the company can’t operate another business that is not related to its profession. However, the professional corporation can own shares in another company carrying on an unrelated business. For those professions with restrictions, a holding company can be introduced.
The above are significant differences, but the most important difference is the amount that can be invested. If you are able to contribute the maximum amount to your RRSP each year, you are limited to about $24,000 annually. There is no limit to the amount you can leave in your company, or transfer to a holding company, for investment purposes. If you don’t need the funds for living expenses, you can leave $10,000 or $100,000 or more in the company each year.
Like the TFSA and RRSP, the professional corporation is an important tool for saving and investing.
In my next posts I’ll provide numeric examples of the advantage of investing through your professional corporation and explain how investments are taxed in a company.
- Incorporation – A Brief Introduction
- Professional Corporations in British Columbia
- Professional Corporations – Why Incorporate?
- Incorporation Benefit – Lower income Tax Rates
- Incorporation – Taxation of Salary and Dividends
- Incorporation Benefit – Income Splitting
- Income Splitting with a Professional Corporation can Save You Thousands
- Incorporation Benefit – Tax Deferral