Like the TFSA and RRSP, the professional corporation is an important tool for investing and saving. By incorporating your practice or business and investing unused funds within the corporation, you will end up with significantly more money in the future than if you did all your investing personally.
Advocates of incorporation always cite the tax deferral resulting from the difference in the small business rate on active income within a professional corporation compared to the personal tax rates on the same income as being one of the primary reasons to incorporate.
You will often read or hear:
You can keep more after tax money in the company to invest than if you earned it personally.
This sounds great. Buy why? Don’t you have to take the money out of the company and pay tax on it at some point? How does keeping more money in the corporation for investing help when you still have to pay the tax when you take it out?
As I have discussed in previous posts, the low income tax rate in the company only provides a tax deferral. However,the deferral can be converted to a permanent tax savings if the funds are taken out as dividends when you are in a lower tax bracket or when you can split income with lower tax bracket family members in the future.
But the tax deferral still provides a significant advantage without future income splitting or lower tax brackets, even when you take into account that investment income in a company does not qualify for the low rate on active business income.
The answer is simple:
It takes money to make money.
Imagine that you are in the highest personal tax bracket and earn an additional $10,000 which you plan to invest for an annual return of 10% 1.
If the $10,000 is earned personally, you will have $5,630 to invest after tax. If invested at 10% for a year, you will have another $317 after tax.
If the $10,000 is earned in a professional corporation, you will have $8,650 to invest after tax. In a year, you will have another $470 after tax in the company.
You will have earned $153 more after tax than you would have personally. If you took this extra amount out of the company as a dividend, you would have $150 after tax personally. This is money that you would have never received without incorporating 2.
$150 doesn’t sound like a lot of money, especially on an investment of $10,000, and it isn’t.
But what if you don’t take the money out?
What happens if you leave that extra $10,000 and the resulting investment income in the company for 20 years? After taking the funds out as a dividend after 20 years, you end up with an extra $5,000 if you are still in the highest tax bracket, and an extra $15,000 if you have no other income in the year of withdrawal.
What happens if you earn an extra $10,000 each year to invest for 20 years? You end up with an extra $45,000 if you are still in the highest tax bracket, and an extra $65,000 if you have no other income when you take the funds out of the company.
What happens if you earn an extra $50,000 each year to invest? By incorporating, you end up with an extra $225,000 if you are still in the highest tax bracket, and extra $245,000 if you have no other income when taking the funds out of the company.
Through the power of compounding over time, you generate significantly more investment income in the company compared to if you did your investing personally, resulting in more funds personally when eventually taken out of the company.
The length of time, rate of return, timing of withdrawal, and type of investment all impact the advantage of saving within a company over saving personally. I’ll explore this in more detail in my next post.
- 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
- Using a Professional Corporation for Investing
- I know it’s not the most realistic rate, but for illustration purposes it’s a nice round number. In the interest of full disclosure, I am also using 2013 personal and corporate tax rates in my calculations and assuming no change in the future. ↩
- The combined personal and corporate tax rate paid on investment income in a company subsequently paid out as a dividend is essentially the same as if the investment income is earned personally. The mechanics of this will be the topic of a future post. ↩
Very helpful illustration. Compounding is a concept that is so often lost on people. Thanks for helping with some creative examples!
Great info on professional corporations and the RRSP. Awesome post!