I have developed an online simulator to model some of the most common dilemmas about how incorporated professionals should pay themselves and save for the future:
- Do I solely invest through my corporation and pay myself only with dividends?
- Should I take some salary and also use an RRSP? What about CPP?
- Should I take out some extra money from my corp, taking a tax hit now, to invest in a TFSA for the future?
- How much will I end up with after the tax-person cometh? And when?
For those who just want to play with it, the simulator is here or can be found in the right margin of most pages (bottom on a tablet). It runs best on a real computer or a high-end tablet because there is a tonne of stuff happening under the hood. It is personally customizable and I will use the simulator to explore some specific different scenarios in future posts to illustrate the key concepts.
For those who want to learn about the inner workings and assumptions, read on. It is a bit technical, but I want to lay it all out there for transparency. Put on your helmet. Grey-matter-resistant screen-protectors are advised.
Some consider the above questions settled. Others don’t.
Ben Felix wrote what I think is the best examination of the issue with his A Taxing Decision Paper in 2017. It showed that an RRSP and TFSA will yield a larger after-tax lump of money when liquidated in the future compared to a corporation. The RRSP is even more attractive if you drop tax rates in the future and the TFSA more attractive if your future tax rate rises. For the TFSA, the timeframe is also important with a longer time-frame being attractive and a short time-frame detrimental. The advantage of diversifying outside of a corporate account held up even when RDTOH refunds were diddled with at the highest tax brackets.
Jamie Golombek has also written about RRSP vs Corp and TFSA vs Corp with similar findings. He also made the observation that the types of investment income could matter. A purely tax-deferred capital gains investment (like swap ETFs for example) could have a corporation outperforming.
Despite this, physicians and other high-income professionals still get variable opinions from their accountants on whether to use an RRSP or TFSA. People’s individual situations vary and they need to choose a good accountant to advise them.
Accountants can provide some rational reasons to invest only in the corporation. On a single-year basis, the corp can sometimes come out ahead depending on the details of the inputs and outputs. The need to pay into the Canada Pension Plan (CPP) when using salary influences this. Further, the need to dispense dividends to keep the corporate refundable taxes flowing has an impact that changes as the portfolio grows. Same with the new corporate passive income tax rules. I hope to account for them all with this simulator over long time-frames and with multiple outcome measures.
Corporation vs RRSP vs TFSA Calculator Inputs
Baseline Investment Account Balances
You can enter existing balances for a corporate account, RRSP, and TFSA at the top of the income input page. The accounts will only be added to if that is part of the strategy being compared.
The Comparative Strategies
Corp Div Only: This strategy only invests via the corporation. It only pays out personal income as dividends. The argument usually presented in favor of this strategy is that it avoids contributions to CPP which is likely to have a safe, but low, rate of return. Dispensing lots of dividends also helps to keep the RDTOH flowing back to the corp. These factors mean more capital in the corp to grow on a tax-deferred basis.
Corp Div TFSA: This strategy is the same as above, except that extra dividends are paid out to fund a personal TFSA.
Corp RRSP: This strategy pays out salary. The maximum RRSP contribution possible for that salary is made each year. Some extra dividends are dispensed to fund the RRSP contribution without affecting cash flow. This also helps keep the RDTOH flowing. The remainder of the corporate retained earnings are invested via the corp. Employer and employee contributions are made to CPP.
Corp RRSP & TFSA: Same as the RRSP strategy, except extra dividends are also dispensed to fund a TFSA.
I also made a Salary only strategy where salary was paid from the corp, but no RRSP or TFSA used. It was consistently a big loser. So, I left it out to simplify what is already an overwhelming calculator for most people.
How money flows through our corporation and into our personal hands is complex. There are a number of variables: the gross corporate earnings, salary paid to the owner, dividends paid, taxes on active and passive income, and possibly CPP or EI.
Tax rates and tax integration also vary between provinces. So, you can select your own province.
Corporate Active Income
The simulator allows you to enter the gross income of your business. The corporate active income and your personal income are assumed to stay the same (when adjusted for inflation) as time passes.
Accordingly, all outputs for the future are in inflation-adjusted “current” dollars rather than nominal dollars. Predicted average future inflation is adjustable in the Returns tab.
Corporate Passive Income
If you already have a large corporate account, you can enter the value. A baseline annual investment income is calculated. It is based on the corporate account value, asset allocation, and predicted returns.
The one exception to inflation-adjustment is the aggregate investment income (passive income) of the corporation used to determine the passive income reduction of the small business deduction. Unlike most income taxes, the passive income limit is not indexed to inflation. Nasty and sneaky, but I am not holding my breath for the government to change that.
The active and passive corporate income, taxes, and retained earnings accounting for the personal income dispensed is displayed.
Set a personal salary and dividend level that gets you close to the after-tax cash flow that you want. You can look in the Corp/RRSP strategy column to see the cash flow. The calculator will then automatically adjust the dividends dispensed according to the different investing strategies.
Income Adjustment: Controlling for single year personal cash flow.
The simulator adjusts the money dispensed for each strategy to provide the same personal after-tax and after-investing cashflow. This is important because this is the money that we need to live on. Our savings work around that. Both the personal and corporate cashflow and taxes are accounted for.
It does this by using a base salary (if using an RRSP) and then taking out extra dividends to make up cashflow as needed. If not using an RRSP, then only dividends are used and the extra cash flow needed for a TFSA is also made up by dispensing extra dividends.
The calculator will also attempt to dispense dividends in the most tax-efficient way possible. It will dispense enough non-eligible dividends to release the nRDTOH (30% refund) and then use eligible dividends from any GRIP generated by active-income above the SBD threshold as much as possible.
The tax estimators are pretty close, but you still have to manually fine-tune the corporate dividends to make the personal cash flow even between strategies. Manually fine-tune at the bottom of the income tab until on target. The target indicator will “go green” when within $250, but you can usually get even closer as seen in the screenshot above this section.
The default is set at 60:40 stock:bonds with the stocks split between Canada and the World. You can also opt to select a custom asset allocation.
The same asset allocation will be held in the RRSP, TFSA, and corporation with no attempts to optimize by location.
The types of income (interest, foreign dividends, or eligible dividends) affects the tax drag generated. So does the magnitude of the annual yield. The yields are set at their recent historical levels. Tax drag is calculated in each account type annually during accumulation. Foreign withholding tax is deducted where appropriate and is fully or partially recovered depending upon the account-type (RRSP vs TFSA vs Corp). Accounts are rebalanced annually and dividends (net of tax) are re-invested.
Capital gains taxes are deferred until realized. You may realize some capital gains each year depending on annual contributions and how tightly you rebalance. You can set what proportion of capital gains are realized each year. For example, 25% would mean that you realize 1/4 of your capital gains each year. It is set at 10% as the default. Many people contribute enough annually to rebalance without selling. However, that will change as the portfolio grows large relative to the contributions.
The effects of investment management fees are also accounted for. It is set at DIY with passive ETF investing as the default. This can be modified to different manager fees and fund fees. It is assumed that active or passive management strategies have an identical pre-tax return. That fee drag (after-tax) is added to the annual returns and post-fee returns are the index minus fees. Historically, active management tends to produce this return, at best. Management fees are deducted as an expense against investment income.
Changes Over Time
The growth of a corporate investment account is affected by different factors over time. As the income of the corporate account grows, the growth can be stunted by two issues. Not dispensing enough dividends to release a refund of all of the RDTOH and running afoul of the new corporate passive income tax changes. A corporation works best when you are both saving large amounts of money in it, but also keeping enough dividends flowing out of it to get the RDTOH refunded.
When our corporation earns investment income, it is taxed upfront to discourage the use of corporations as purely tax-deferral vehicles. The tax rate is 38.33% on Canadian eligible dividends and ~50% on the rest. For eligible dividends, all of the 38.33% of the eRDTOH is released when we dispense the money out of the corp. For other investment income, it is only released if we dispense ineligible dividends and the nRDTOH refund rate is only 30.67%. A dollar of RDTOH is released for every $2.61 of dividends dispensed. This is illustrated below.
So, if we are not dispensing enough dividends, then there is more tax drag on our investments because of the withheld RDTOH. Since the eRDOTH refund is higher and eligible dividends are taxed more favorably in our personal hands, the release of eRDTOH each year is given priority by the model if insufficient dividends are dispensed to refund all RDTOH (both nRDOTH and eRDTOH).
If there are excess eligible dividends being dispensed from corporate GRIP from active income, then some will be changed to ineligible dividends to release the nRDTOH as long as possible. This is because the savings from using corporate GRIP is about 8-10% and nRDTOH is about 30%.
The above process of optimizing dividends to release RDTOH efficiently is done annually. Unreleased nRDOTH or eRDTOH is accrued for release when the corporation gets liquidated.
At liquidation, all RDOTH eventually gets refunded, but the tax drag along the way can still stunt portfolio growth on the journey to get there.
Hitting The Active-Passive Corporate Income Tax Threshold
How soon the corporate passive income causes increased tax drag depends on how big the account is. The investment income that counts towards the limit also grows faster with a higher annual contribution rate from retained corporate earnings, a higher allocation of high-yielding asset classes, and a higher turn-over triggering capital gains.
A lower net active income can also delay hitting the passive income threshold. The passive income threshold increases by $1 for every $5 of active income below $500K. Paying a salary and CPP are expenses. That lowers the active income and delays having corporate income bumped up to the higher general corporate tax rate.
Attenuating the Impact of the Active-Passive Corporate Income Tax
When a corporation gets bumped up to the higher general corporate tax rate, its tax rate jumps by about 14-15%. Roughly doubles in relative terms. The exceptions are Ontario and New Brunswick, whose provincial governments have not mirrored the change. That results in only the federal rate rising on those small businesses and not the provincial (~5% increase).
However, active income taxed at the Federal general corporate rate still generates GRIP. That GRIP allows the corporation to give some eligible dividends instead of the higher-taxed ineligible ones. The net effect is a combined tax rate of about 2% higher as shown in the detailed tax integration flow chart below.
Every $1 of passive income above the threshold bumps $5 of active income into the higher tax rate. That means a 2% X5 =10% increase in tax for every $1 of passive income over the threshold when using eligible dividends from the generated GRIP. Better than 2% X5=100%, but it still sucks. Avoidance, or delay, in passing the passive income threshold should pay off.
Ontario and New Brunswick with their hybrid Federal/Provincial tax rate from going over the threshold while still generating GRIP (and benefiting from dispensing eligible dividends) attenuate the impact even further. That is more complex and will be examined in another post, but the calculator does account for this mechanism.
How the passive income tax hike and threshold are handled by the model.
For the model, as more active income is taxed at a higher rate, the extra drag from the difference between the general corporate tax rate and the small business tax rate is included in the corporate investment tax drag. It is only added to the income above the threshold. The tax drag stops increasing when the small business deduction on active income has been completely eliminated. While the tax is on active income, this is being driven by passive income.
If able, that is counter-acted as much as possible by dispensing eligible dividends.
If the corporation is giving more than enough dividends each year to release all of its eRDTOH and nRDOTH, then some of the excess dividends can be changed from ineligible to eligible dividends using the GRIP balance. That attenuates the effect somewhat as described above. The calculator uses an exact calculation for the specific tax bracket and province, but the eligible dividend savings compared to ineligible is usually in the 8-10% range. That means fewer dividends need to be dispensed to maintain personal cash flow and more retained earnings can be kept in the corporation to invest.
That 8-10% saving is much less than the 30% nRDTOH and 38% eRDTOH refunds. So, when there are not enough dividends to release everything, the eRDTOH is given first priority, then nRDTOH, and then using the active income GRIP.
Accounting for the Canada Pension Plan
If you pay a salary, then you also have to pay into the Canada Pension Plan (CPP). As a self-employed person, you must pay both the employer and employee contributions. That means less money in your corporation and your personal hands to invest. This often turns people away from salary – but is that rational?
CPP is often confused as a tax. It is not. It is a pension.
That means that it is invested, will grow, and will one day pay benefits. The question is whether the CPP is a good pension. How much CPP will pay in the future is complicated, but it is an inflation-indexed defined benefit plan to replace 25% of the income that CPP contributions are collected against. Over the next 4 years, the contributions will increase and the target benefit also increases to 33% of pensionable income (Enhanced CPP).
We can expect to get some blend of CCP/Enhanced CPP depending on how our career straddles the transition. The CPP real return will work out to be about 2-2.5%/yr above inflation for those born after 1970.
The argument then follows that you are likely to beat 2.5%/yr investing on your own. Therefore, you should avoid it (by avoiding salary) and invest on your own via your corporation. There are actually a number of other problems with that argument that I will have to expand on in another post.
The simulator accounts for CPP in several different ways depending on the outcome being examined.
CPP as Part of Accumulation Portfolio Value
- During the accumulation years, the loss of money to contribute to CPP is deducted against your personal and corporate cashflow. This makes the comparison between strategies fair.
- Enhanced CPP will be phased in over the next five years. To make it a worst-case-scenario for CPP, I used the planned higher 5.95% for employee plus 5.95% for employer contribution rates right away.
- The contributions grow and that is counted as part of your total portfolio value. The default return is set at 4%/yr with 2% annual inflation for a 2%/yr real return. The CPP contributions will grow at 2%/yr and that is included in your overall retirement portfolio value. You can adjust both returns and inflation if you don’t like my guesses.
- Counting CPP contributions/growth was used here because it is not really wasted money. It is like a pot that you can draw from or like buying an annuity. It has value.
CPP At Drawdown
At drawdown, the calculator estimates CPP benefits based on your years worked and dropping as many years after age 18 as allowed. That drops out the potentially lower-earning years while training. You are usually allowed to drop 7 or 8 years from the CPP calculation depending on when you collect.
The benefits are then calculated using the personal income from your input with no changes over your career span. Entering your current age on the Income input tab allows the calculator to figure out how much of your contribution/benefit was at the CPP rate and how much at the Enhanced CPP rate.
CPP cannot be collected before age 60 and could be delayed to age 70. However, the calculator drawdown output is the first year retirement income. If the retirement age is below the CPP collection age, the CPP is still added in. This makes the comparison between strategies fairer because you will collect CPP someday. However, it would not be accurate in that you wouldn’t really be collecting CPP yet.
The ideal would be to show annual income over time, but that would eat up too much computing power. Perhaps a separate calculator in the future…
CPP Value At Portfolio Liquidation (Death)
If you die, the “true value” of your CPP would be zero. You really don’t own anything.
However, if you have a dependent/spouse who does not already receive the maximum CPP, it does have some “equivalent value”. If you have a spouse who has little or no CPP, then they could get up 60% of your CPP benefit up to the maximum individual CPP amount. That also means that if they already collect CPP, then they may not get much of yours – just enough to top them up to the personal maximum.
So, there is some potential for CPP contributions/growth to be passed on to a spouse. Otherwise, there is not really any CPP value to add to your estate. That made it challenging to account for CPP as a “value” at liquidation. I made the options to include, exclude, or use half of the CPP survivor benefit. That would add 60%, 0%, or 30% of the “equivalent value” of your CPP contributions/growth after subjecting them to the maximum tax bracket. That is probably a bit harsh on the taxation, but I want to be conservative when estimating CPP “value”.
RRSP vs Corp vs TFSA Simulator Outputs
There are a number of ways to look at the wealth built via different investing strategies. The simulator produces three:
- Accumlation (tax drag applies, but it is pre-tax for tax-deferred accounts)
- Drawdown Income (1st year of after-tax retirement income)
- Post-Tax Liquidation Value (you die and everything is liquidated and taxed)
Accumulation Period Results
Total Portfolio Size During Accumulation
This displays the growth of all applicable accounts (Corp, TFSA, RRSP, and CPP) in the portfolio lumped together. It is calculated annually, adjusting for the annual contribution, erosion by inflation, and the drag from annual taxes.
The annual tax drag includes non-refundable foreign withholding taxes (FWT). All FWT is lost in a TFSA. In the RRSP, the Canadian-listed ETFs holding US or Non-North American Developed market stocks directly were used to keep FWT to one level. For emerging markets, a Canadian-listed ETF will have an extra layer of FWT that is not recoverable. FWT was assumed to be 50% recoverable in the corporate account.
In the corporate account, there can also be annual tax drag from the non-refundable portion of tax on investment income and any RDTOH that is not refunded in that year. If a proportion of capital gains are realized annually, then they are taxed as investment income at the 50% inclusion rate. The nRDTOH from that is pooled with the rest and the capital dividend account accrues.
The pre-tax total portfolio value at 5-year intervals is shown in a table. The table also highlights the year that the dividends dispensed are no longer enough to fully release the RDTOH and the year that the passive income limit is first passed.
The annual portfolio values are displayed as a chart. You can see exact values hovering over the chart.
Annual Returns During Accumulation
The inflation-adjusted-after-tax-drag return is calculated annually and displayed as a chart. This illustrates the effects of the above tax drag changes during accumulation.
Drawdown Period Results
This section shows how much annual income you could receive at retirement. You can adjust the retirement age, CPP collection age, and the withdrawal rate at which you plan to drawdown your accounts.
The withdrawal rate is set at what would be considered a safe rate (>95% chance of not out-living your money with a 50:50 stock:bond portfolio). That is adjusted lower for longer retirement periods and for the effect of management fee-drag as described in this article. If you don’t like that methodology, then the safe pre-fee-pre-tax-withdrawal rate is adjustable.
The percentage withdrawal is drawn equally from all account types. This is likely less efficient than an optimized sequential withdrawal (like corp before RRSP before TFSA). However, it was the only way to make the calculator workable as a webpage and still illustrates the important points.
Income Drawn From The Corporate Account
The income drawn from the corporation consists of several parts. The accrued capital dividend account and any accrued RDTOH from the accumulation years are distributed evenly over the expected retirement duration. For example, a $100K capital dividend account for someone retiring at 70 and projected to die at 90 would be dispersed as a $5K capital dividend per year. Newly generated RDTOH or capital dividends are annually dispensed on top of this.
Capital gains in the corporate account are only realized if required to make the 3%/yr withdrawal after income from interest and dividends has been passed through. This maximizes capital preservation and tax-deferral.
Income from the corporation is dispensed as eligible dividends, capital dividends, and the remainder as ineligible dividends. If excess GRIP was generated from corporate active income during the accumulation years, it is ignored. This is because the tax drag from not getting the nRDTOH refund (30%) by switching from an ineligible dividend is worse than any savings gained through using an eligible dividend instead (8-10%).
Income Drawn From The RRSP & TFSA
RRSP withdrawals are added as fully taxable income. It is withdrawn at 3%/yr. In reality, you may start drawing early. Conversely, you may have to make larger withdrawals based on your age once you’ve converted to a Registered Retirement Income Fund (RRIF). That was too complicated to model. Plus, it could make the RRSP appear better on an annual income snapshot even though you are depleting your RRSP capital faster.
Income drawn from the TFSA is tax-free.
CPP Benefit Estimation
An estimated annual inflation-adjusted CPP/Enhanced CPP benefit is added into the retirement income. The bottom of the Drawdown page shows details of the calculation and assumptions made.
CPP benefits are added as fully taxable income.
After-Tax Annual Retirement Income
The income from the above sources is added together and inputted into a tax estimator. The tax calculation accounts for income, dividend gross-up/credits, and basic personal amount. It doesn’t do anything fancier like age-related tax credits or pension-splitting etc. Still, it gives a decent rough estimate and is consistent between strategies which is what matters for comparison.
This is what most people probably care about. So, I highlighted it as orange.
Portfolio Liquidation Results
What if you never drew from your portfolio, but died prematurely and liquidated it in one year? Well, that would suck. Regardless, this is another way to look at the after-tax value of your portfolio. In this analysis, the entire portfolio is liquidated and taxed at the highest marginal tax rate.
The RRSP is taxed at the max personal income tax bracket. This is an overestimation of tax. However, that would be negligible with a large estate.
The corporation is dispensed as eligible dividends, ineligible dividends, and capital dividends to make sure all of the notional tax accounts are emptied out.
The TFSA is passed on tax-free.
Accounting for CPP is a bit of a challenge here. I commented on that earlier in the post. It does make a difference and may account for some of the variable tax advice.
The post-tax total value of the portfolio is shown both in table and chart format. Each data-point represent the value if you were to die at that particular age and liquidate your accounts.
Where to Next?
Well, if you managed to read and understand all of that, you will realize that there is a lot going on in the background in making this kind of simulation. That probably accounts for why there is variable advice about the use of RRSPs, TFSAs, and corporations. To be clear, I advise that people use professional advice for their personal situations. However, hopefully, you will find this calculator educational and entertaining (in a financial-nerdy-kinda-way). Run your own numbers. If you find bugs, report them to me. Other feedback welcome – just be gentle – this thing was a beast to make.