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withdrawals in the future, while the money remaining in their corporation will ultimately be taxable when the funds are withdrawn as dividends.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. Please note the blog post is time sensitive and subject to changes in legislation or law.