My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, June 29, 2015

Should You Fund Your TFSA With Corporate Funds?

Many business owners and professionals operate through corporations. One of the main benefits of using a corporation is the deferral of income tax (over 34% in some provinces) and as a result, many business owners attempt to leave as much money in their corporation as possible (in essence to build their own mini corporate retirement fund).

When Tax-Free Savings Plans (“TFSAs”) were introduced in 2009, most small business owners typically had a choice of two pots of money to fund their annual $5,000 contribution limit. They could fund their TFSA with non-registered money (savings accounts or brokerage accounts) or withdraw funds from their corporations.

Initially, most chose to fund their TFSAs with non-registered money, since this money had already been taxed. However, as time marched on, many people exhausted their non-registered money in funding their TFSAs or used these funds for their personal use, such as to renovate their homes, vacations etc.

Funding an owner/manager’s TFSA has become even more problematic with the proposed TFSA increase from $5,500 to $10,000 announced in the March, 2015 budget. Some of my clients who do not have any available non-registered money to fund their TFSAs have automatically assumed they should fund their future contributions with corporate funds, as opposed to leaving the funds in their corporations and not funding their TFSAs.

Their thinking is premised on the belief that their TFSAs will provide for tax-free withdrawals in the future, while the money remaining in their corporation will ultimately be taxable when the funds are withdrawn as dividends.

As I have also been contemplating the question of whether you are better off funding a TFSA with corporate funds (via a dividend), or not funding a TFSA at all and growing a corporate "retirement account", I decided to run some numbers to see what they reflected.

Based on some simple calculations (provided below), the answer is not necessarily clear cut, although in general, it appears you will in most cases want to fund your TFSA with corporate funds. I provide some general guidelines below.

For the mathematicians out there, please do not have any heart palpitations. I concede a vigorous analysis would include various permutations, combinations and Monte Carlo simulations, but I have neither the tools, nor the time to undertake such an analysis.

The BBC’s Analysis


In undertaking my calculations I made some large assumptions.

1. The individual taxpayer is at the highest marginal rate (in Ontario).

2. The initial active income earned in the corporation was taxed at the lowest corporate rate of 15.5% (in Ontario).

3. I assumed a 30 year investment horizon and I used a flat 5% rate of return on the money, whether the income earned was interest, capital gains or dividends (of course in real life, typically the return on capital gains would be far in excess of that of interest and dividends), but you need to have a standard comparison point.

4. For purposes of this exercise, I assumed all dividends received are eligible dividends from Canadian public companies. 

What Did I Determine


My calculations reflected the following:

1. If you are earning interest in your corporation, you are clearly better off removing those funds via a dividend and investing the after-tax proceeds in your TFSA.

2. If all you are earning is capital gains, you are probably better off leaving those funds in your corporation, rather than removing the money via a dividend and funding your TFSA.

3. If you are earning eligible dividends in your corporation, you are better off removing the funds from your company. However, the timing and your marginal tax rate at the time could change that decision.

Since most portfolios earn a blend of interest, capital gains and dividends, depending upon the actual mix (this is why you would need to run your own numbers), you will likely want to use corporate funds to invest in your TFSA.

I should note that I did play around a little with income tax brackets. I compared the $44,701- $72,064 and $89,401-$138,586 income tax brackets to the highest marginal rate bracket. I determined that at the lower brackets, there is a slightly larger bias to funding your TFSA with after-tax corporate funds for all types of income, but the differences were not compelling.

As noted above, a rugged analysis would require multiple simulations which I don't have the tools to undertake. This analysis would take into account the different corporate tax rates, rates of return, income levels, future and current tax rates, income smoothing, portfolio allocation and investing style (some people only invest in higher risk equities that will produce capital gains in their TFSA - i.e. the greatest upside with no tax).

I would like to think this post was not an exercise in mathematical futility. Instead, I hope it gives you reason for pause in automatically assuming you should fund your TFSA with corporate funds, as opposed to leaving those funds in your corporation to grow over time. In order to ensure you make the correct decision, you need to review this issue with your accountant taking into account your specific income tax and investing circumstances.

The Calculations



Year 1
Corporate Income
19,763
Corporate Dividend
16,700
Income Tax 15.5%
3,063
Personal Tax 40.13%
6,700
Net Proceeds
16,700
Net personal
10,000



TFSA
Funds
Five %
Total
Return
Year 2
10000
500
10500
Year 3
10500
525
11025
Year 4
11025
551
11576
Year 5
11576
579
12155
Year 10
14775
739
15513
Year 15
18856
943
19799
Year 20
24066
1203
25270
Year 25
30715
1536
32251
Year 30
39201
1960
41161



INTEREST
Funds
Five %
Corp Tax
RDTOH
Net Return
Return
46.17%
26.67%
(A)
(B)
(C )
(D)
A+B-C
Year 2
16,700
835
386
223
17,149
Year 3
17,149
857
396
229
17,611
Year 4
17,611
881
407
235
18,085
Year 5
18,085
904
417
241
18,572
Year 10
20,653
1033
477
275
21,209
Year 15
23,587
1179
544
315
24,221
Year 20
26,936
1347
622
359
27,661
Year 25
30,762
1538
710
410
31,590
Year 30
35,130
1757
811
468
36,076
RDTOH
9,600
9,600
Dividend paid
45,676
Tax on dividend
Tax 40.13%
18,330
Net Proceeds
27,346

  
CAPITAL GAIN
Funds
Five %
Corp Tax
RDTOH
Net Return
Return
23.09%
13.33%
(A)
(B)
(C )
(D)
A+B-C
Year 2
16,700
835
193
111
17,342
Year 3
17,342
867
200
115
18,009
Year 4
18,009
900
208
120
18,702
Year 5
18,702
935
216
124
19,421
Year 10
22,585
1129
261
150
23,453
Year 15
27,274
1364
315
181
28,323
Year 20
32,938
1647
380
219
34,204
Year 25
39,777
1989
459
265
41,307
Year 30
48,037
2402
555
319
49,884
43,146
9,962
5,738
Capital dividend        50%*$43,146
-21,573
Funds available for dividend
28,311
RDTOH paid out
5,738
5,738
Dividend paid
34,049
Tax on dividend paid
Tax 40.13%
13,664
20,385
Capital dividend paid out tax free
21,573
Net proceeds
41,958





ELIGIBLE DIVIDEND RECEIVED

Funds
Five %
Part 4 Tax
RDTOH
Net Return


Return
33.33%
33.33%


(A)
(B)
(C )
(D)
A+B-C
Year 2
16,700
835
278
278
17,257
Year 3
17,257
863
288
288
17,832
Year 4
17,832
892
297
297
18,426
Year 5
18,426
921
307
307
19,041
Year 10
21,709
1085
362
362
22,433
Year 15
25,577
1279
426
426
26,430
Year 20
30,134
1507
502
502
31,139
Year 25
35,503
1775
592
592
36,686
Year 30
41,828
2091
697
697
43,222
RDTOH
39,782

13,259
13,259
Dividend paid

56,481
Tax on eligible dividend ($39,782*.3382)

-13,454
Tax on ineligible dividend ($16,699*.4013)

-6,701
Net proceeds

36,326




Note: I apologize for the formatting on the dividend chart. I made a change and now cannot get it back to its original format.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.