RRSPs Overlooked As Personal Net Worth
While many entrepreneurs count the value of their business as a key component of personal net worth and a significant contributor to retirement income, it's also essential to establish a Registered Retirement Savings Plan (RRSP) and to maximize contributions to it.
"Many small business owners rely on the sale of their business to fund their retirement, which can be a risky approach if you can't sell for the price you need or you are forced to step away from the business sooner than you planned," says Gail Cocker, senior vice-president, BMO Commercial Banking. "It's important for business owners to look at the bigger picture and have a diversified financial plan that also includes an RRSP."
Value Of Business
A BMO survey found that 13 per cent of small business owners in Canada don't know how the value of their business may have changed since the recession. A varied approach to planning, including an RRSP, can help entrepreneurs ensure a secure retirement income.
There are a number of reasons why small business owners should consider an RRSP:
- Diversification ‒By contributing to an RRSP, you establish a source of income independent from your business. In the event that the sale of your business doesn't provide the capital you need, you can count on your RRSP to provide you with retirement income.
- Tax benefits ‒ Every dollar you contribute to an RRSP reduces your taxable income for the year of contribution. Within the plan, the tax on investment income is deferred until the year of withdrawal. Over the long term, the power of tax-deferred compound growth is substantial.
- Security ‒ As a business owner, you know that your business can be affected by factors beyond your control such as an economic downturn. An RRSP that holds conservative investments such as Guaranteed Investment Certificates (GICs), government bonds or Treasury bills is an effective way to offset the volatility of your business returns.
- Flexibility ‒ The primary goal of an RRSP is retirement savings, but it can also be used for other purposes. For example, under the Home Buyers' Plan you and your spouse can withdraw up to $25,000 each tax-free from your RRSPs to use as a down payment on your first home. You have to pay the money back, but your first payment isn't due until two years after the year of withdrawal. Under the Lifelong Learning Plan, you can withdraw RRSP funds to pay for education for yourself or your spousal partner.
- Bargaining power ‒ With the strength of your RRSP behind you, you're in a better position to hold out until you find the right buyer for your business.
- Protection ‒ If you or your spouse experience unexpected health problems later in life, you might need to exit your business sooner than you had planned, perhaps at an unfavourable time to sell. With the resource of your RRSP, you'd be in a better position to still achieve your desired retirement lifestyle.
- Reliability ‒ At any time, you can convert your RRSP to an annuity that will provide you with guaranteed income for life. You must convert your RRSP to an annuity or Registered Retirement Income Fund (RRIF) by the end of the year you turn 71.
"For entrepreneurs who didn't contribute to their RRSP, there are still a number of tax-planning opportunities that can significantly help small business owners to achieve tax-efficient long-term savings," says Cathy Pin, commercial banking, BMO Bank of Montreal. "Business owners can work with a tax expert to take advantage of the various tax-saving strategies available to them."
Tax strategies for long-term savings include:
- Income Tax Reductions ‒ By incorporating their business, entrepreneurs will enable their business income to qualify for the small business tax reduction. This can reduce the combined corporate tax rate on the first $500,000 of active business income to as low as 12 per cent. The reduction may be available if your company qualifies as a Canada Controlled Private Corporation (CCPC), carrying on an active business in Canada.
- Exemptions for Capital Gains ‒ Generally one of an entrepreneur's most significant assets is their ownership of small business shares. When it is time to retire and the owner wishes to sell the business, he/she can qualify for a lifetime capital gains exemption of up to $750,000. Appropriate planning should be done with a tax professional to ensure that the entrepreneur has access to this benefit; some complex rules apply, including that the claimant must have owned the shares for at least two years before selling.
- Remuneration Options ‒ Small business owners who have incorporated their business have greater flexibility in determining how to be compensated, such as choosing to pay themselves a salary, or a dividend, or both. For example, a reasonable salary can create personal RRSP room, provide a deduction for the business, and help bring business taxable income below the $500,000 small business deduction limit. On the other hand, if the business income in excess of $500,000 is retained in the company, it is taxed at a lower rate than would be paid on the salary or bonus paid to the owner. The corporate after-tax income may be paid as a dividend and may be taxed at an overall tax rate lower than a salary or bonus. A dividend is not tax deductible for business tax purposes.
- Income Splitting ‒ Family-run businesses can capitalize on income-splitting by hiring a spouse or children on the payroll since a reasonable salary is deductible to the business. They pay the tax themselves and, if they pay at a lower rate, there could be tax savings for the family. However, ensure their pay is reasonable, their roles in the company are clearly defined, their performance is well documented, and the amount paid is not a redistribution of income from the entrepreneur. It must be truly paid for services rendered to the business.