One big decision I need to make as I transition from salaried employee to entrepreneur is whether to take a salary from my business or pay myself dividends. I set up a corporation for my online business back in 2012. My wife and I are 50/50 owners of the small business, and we’ve used the corporation to stream dividends to my wife for the past seven years. I earned a salary and my wife stayed home full time, so this structure allowed us to split our income somewhat and save on taxes.
We’ll need to change things up next year and decide whether to pay ourselves a salary, continue to pay dividends, or come up with some combination of the two.
Pros and cons of a salary
The main advantage of taking a salary from the business is that it will give us a personal income. That means we’ll pay into CPP, and also earn contribution room for our RRSPs. A salary paid out will also be a tax deduction for our small business.
One potential disadvantage is the pain-in-the-ass factor of setting up a payroll account with the CRA and filing all of the related paperwork. We’ll also have to pay into CPP twice as both the employer and the employee. Finally, personal income is taxed at a higher rate than dividend income, potentially increasing our tax burden.
Pros and cons of dividends
We’ll definitely pay less personal tax since dividends are taxed at a lower rate. My quick estimate is an average tax rate of 13 percent with dividends, versus 27 percent with a salary. We’ll also save money (today) by not paying into CPP.
Dividends can be declared at any time, helping smooth out our cash flows throughout the year, and optimize our tax situation come tax time.
Paying dividends is fairly straightforward. We simply write a cheque to ourselves and then update our corporate minute book.
The disadvantages of receiving dividends is that we won’t pay into CPP, which will lessen our entitlements in retirement. We also won’t have eligible income to create RRSP contribution room.
Salary vs. Dividends: Why not do both?
An accountant once told me to pay ourselves a salary up to the RRSP contribution maximum and then top-up with dividends as needed. He also suggested to leave as much money in the corporation as possible to keep taxes low.
Reality check. The RRSP contribution limit is 18 percent of income, up to a maximum of $26,500 (2019). To earn the maximum deduction limit you’d need income of $147,222. Each. That’s not going to happen.
A more realistic approach for us would be to pay ourselves enough salary to max out the Year’s Maximum Pensionable Earnings (YMPE) for CPP. The CPP maximum for 2019 is $57,400.
We plan to pay ourselves between $66,000 and $70,000 each to meet our spending and saving goals. So we could pay ourselves a salary of $57,400 and then top-up with dividends for the remainder of our needs.
This hybrid approach would allow us to max-out our CPP benefits, while also creating ~$10,000 each in RRSP contribution room per year.
This Week’s Recap:
November is Financial Literacy Month and this week I asked whether banks should have a hand in promoting financial literacy.
Over on the Young & Thrifty blog I took a long look at passive investing and why it’s about to finally take off in Canada.
I went on a bit of a shopping spree at Amazon recently, in anticipation of some extra free time on the horizon. I’d like to read more in 2020, and I’m getting a head start now.
I just finished Malcolm Gladwell’s latest – Talking to Strangers: What We Should Know about the People We Don’t Know. In the typical Gladwell fashion, he shares several interesting stories that are all connected around a central theme. It’ll have you questioning your own assumptions around complex topics like police shootings, terrorism, espionage, sexual assault, and deception.
Next on my list is Profit First: Transform Your Business from a Cash-Eating Monster to a Money-Making Machine.
Weekend Reading:
What’s the best Aeroplan credit card? The Credit Card Genius team compares the TD Aeroplan Infinite Visa vs. the American Express Gold Rewards Card.
Not sure how to get the most out of Aeroplan? Read how I maximized Aeroplan flight rewards for our epic trip to Scotland and Ireland.
Millennials are facing all the risk and none of the reward in today’s financial realities.
Millionaire Teacher Andrew Hallam explains how retirees can withdraw more than 4 percent per year from their investments.
Shane Parrish says better “mental models” are vital to improve society. How what’s in our heads changes what’s in the world:
“When we understand how someone sees the world, a lot of their actions and beliefs start to make sense. The medical profession offers a helpful model. Would you think highly of a doctor that offered a diagnosis without first understanding your symptoms?”
Collaborative Fund’s Morgan Housel explains what a spectrum of wealth would look like if you described it with words, not numbers.
Here’s a hodgepodge of smart investing commentary from Downtown Josh Brown and the Irrelevant Investor Michael Batnick:
Dale Roberts looks for an explanation as to why Canadians have given robo-advisors the cold shoulder? I’ve also wondered this.
Another reason to avoid time-shares. A Thornhill woman said she can’t get out of her timeshare agreement more than three years after she paid a company over $4,000 to break the contract.
My Own Advisor’s Mark Seed gives an update as he zeroes in on his financial independence goals.
Finally, this man tested Canada’s tax laws by moving in a canoe – and he won.
Have a great weekend, everyone!
