Jon Orr: In this episode, we're going to answer the question about and I guess the debate is about how much should I be contributing to my RRSP each year? Whether I'm a T4 employee or a business owner or an incorporated business owner, how much is the right number? And how much am I contributing too much or am I contributing too little? Should I avoid the RRSP because it doesn't make sense about thinking about I'm gonna have more money in the future and therefore I'm gonna be paid tax. It doesn't make sense to defer. Maybe I should be paying myself more than pull more money. These are the questions we're gonna answer here today. This is your guide to RRSPs.
Let's kick it off with a case study because we just got off a call from an individual we've met with a number of times and they were in the situation where they were flip flopping all from one side to the other of mindset around RRSPs. Let's get into the details so you can pull the required information for yourself so you make the right call.
Kyle Pearce: I love it. Yeah, this is a really challenging topic. And the problem, especially for business owners, is you have a lot more choice than someone who, let's say, is working for another outside employer that they don't actually own shares in the business. They're going to receive the T4 income that they receive. And therefore, the discussion around RRSPs, I think, is a little bit easier. However, it's still not a hundred percent easy.
So for example, a couple of rules of thumb that I like to start with when you're younger, and let's say you're in lower tax brackets, you really want to look and for ourselves, John, you remember this. We were earning less than half of what we were planning to earn as we looked down that grid as teachers. You know, we were looking down the grid and we knew eventually we were gonna hit the top of the grid and we were gonna make a certain amount of money. There's a lot of people out there who have careers like that.
Or you maybe are early in the career, you're a junior on the team and you want to work your way up and you might be earning a little bit less. So when we're in low tax brackets and that RRSP room is there, it might be attractive to put some money in. And to be honest, I don't think it's going to make a massive difference if they chose to do that. Now, I don't mean that like in the long run, it will make a massive difference to invest.
But I might choose earlier to maybe save a little bit of that room, pay a little bit of that small amount of tax, and then utilize tax-free savings accounts first, for example. And then of course, if there's money left over, we look at the RRSP and so on and so forth. It's nice to save up some of that room if we see that in future tax years we're going to be in larger tax brackets, especially if you ever think you're going to be in the highest tax bracket, because then an RRSP, of course, becomes incredibly helpful because you can get essentially 50 cents on every dollar that you contribute back from tax. That's massive, massive help.
So the answer here isn't whether like the RRSP is a good or bad. There are some people who are against RRSPs. And I think sometimes maybe wrongfully, you know, make assumptions about, hey, tax brackets are going to go up in the future and it's really bad and all of these things. I think a bigger problem we have is people don't have enough money to take out of their RRSP in order to actually put them in a high enough tax bracket where it's consequential. So I think that argument sometimes is a little bit mute.
However, with business owners, we have choice. Like we can decide how we compensate ourselves. And in this particular case, we've got a great business owner, has grown a strong business. They don't spend a whole lot. So that's really important. On lifestyle, I should say.
Jon Orr: You mean on lifestyle?
Kyle Pearce: Yep, definitely.
So they essentially take about $50,000 each. This is a husband and wife team that are working in the business. Essentially, they've got a few contractors that work for them, but essentially it's all on them currently. And those $50,000 salaries, you know, they're actually not paying that much more in total tax to what they would pay if they left it inside the corporation.
So some people might be wondering: is like, you know, how do I or should I be maximizing my RRSP? And in their case, they spent a lot of time outside of Canada, so they haven't contributed a ton to their RRSPs.
Jon Orr: You mean like they were living abroad?
Kyle Pearce: You know, they came back to Canada, they opened this business. And then on their mind, they've been almost like in a way, like a bit of a FOMO thing between CPP and RRSPs. They're in their early 50s and they're going, our RRSP is pretty small. Like, should we be taking more money out of our retained earnings in order to boost up the RRSP and contribute to CPP credits? Try to get as much CPP as they possibly can.
And it's not a simple answer. But here's the big part. And this one I think is gonna land for a lot of people. In their mind, they were going, well, if we plan to work for say another five years or so, let's try to maximize as much as we can in the RRSP. I'm not against that. But their decision was to double their salaries from $50,000 each to $100,000 each, with the main objective to be topping up CPP credits and to contribute more money to the RRSP. And right away, that throws up red flags for me.
Jon Orr: Okay. Why?
Kyle Pearce: Maybe we're not recognizing what we're giving up in order to do those things. So again, RRSPs are great, but do I want to double my salary in order to open up more contribution room? And I would say that at the onset, someone like myself would say, I don't know if we're recognizing what we're having to give up in order to make that extra additional contribution room.
Jon Orr: Now let me ask you this, because if I'm doubling my salary so that I can take the excess, because clearly they don't need to double their salary for lifestyle expense. Like to live the life that they want, the fifty thousand each was enough. So now doubling it is basically saying now I have an extra hundred thousand dollars between the two of us to not use for lifestyle, to invest or to use for stuffing my RRSP.
And then there's caps on that RRSP as well as a percentage or a flat cap at a certain point, and then maybe invest the rest. Basically to me is saying like, am I doubling my salary just to take advantage of the RRSP room, or am I actually worried about retirement and therefore I actually don't have enough to retire now or in five years, let's say it was? Then therefore I need to start thinking about that. Therefore, my retirement strategy isn't there.
So is my plan to like start to stuff these things so that it will have that time to grow on the personal side, so that in five, six, seven years, when I do retire, now my pot is big enough to start withdrawing from to actually fund my original lifestyle? Or I guess the alternative is like do I just leave it in the corporation to compound and then pull it out at that time because your corporation in itself is a fancy RRSP in a way.
Kyle Pearce: Right, exactly. And I think you brought up a really interesting question, which is, you know, do I have enough for retirement? And I think sometimes too, like we feel that if we put more money in our RRSP, that somehow we're gonna be better off. But in a business owner's perspective, it's like you're the one funding those accounts and you had to take it from a different account to get it there. So the question really becomes is...
Jon Orr: You took it from one RRSP account and moved it to a different, it just crossed the corporate veil.
Kyle Pearce: Exactly. And like I will by all means say that, hey, RRSP, it's fantastic that you pay zero tax on the dollars going in versus any money stuck, quote unquote, stuck in the corporation.
By the way, they are earning less than $500,000 inside of the corporation. So they are utilizing the small business deduction or the small business tax rate. They are here in Ontario. So 12.2% is the magic number there. So again, there is some tax being paid if we leave money in the corporation. And then of course, there's no tax being paid if we put it in the RRSP. So there is some benefit here if we can get more of that money into the RRSP.
Now, if they had lots of contribution room, this might be a different discussion because if they had lots of room, let's say both spouses had $100,000 of RRSP contribution room available, taking an extra $50,000 out of the corporation in order to pay them and then essentially backfilling the RRSP, utilizing that contribution room is not a bad move, right? Like we're looking at this going, hey, you're now going from 12.2% tax to no tax. And that's a wash, that's a clear back of napkin awesome move that they can make.
And the part I really like about it, if they build up a big RRSP, they are low spenders according to today. We'll assume no inflation. We'll assume that brackets will move up with inflation. We'll do all of those things. But if they're only taking $50,000 now for lifestyle and they continue to do so, having money coming out of the RRSP is not going to be the major downside that everybody kind of scares you about on the internet when they talk about RRSPs.
You know, and even we say it can, RRSPs can turn into a tax bomb for some people, but it's still a good tax bomb to have, especially if you were in the highest tax bracket when you had funded it. So for these individuals, I don't necessarily dislike the move if there was contribution room available, but the problem is that there isn't contribution room available.
What they're actually doing is they're actually taking double the salary with hopes of it's not hopes. They know they're going to get more RRSP room. But where I don't think we've thought ahead is how much room do we actually get when we take an extra dollar of salary or bonus from our corporation?
And when we think about this logically and say every dollar we take out of salary, we get 18 cents we can put into the RRSP. You quickly recognize that wait a second, I took a dollar out, I paid tax on a full dollar so that I can take 18 cents and put it in the corporation and get all the tax on that 18 cents back. I don't get the tax back on the other 82 cents. And that is a massive, massive miss in this strategy right now.
Is that if we're going to start paying more tax, so at $50,000 in Ontario, they're paying slightly higher than what they would have paid in the corporation. It's about 13-ish percent total on $50,000. They're now paying a total of what is it, 20% just south of 21% on the whole $100,000. So they're jumping up about 8% in total taxes paid in order to get some tax back on the back end.
And again, they're only opening up 18 cents for every dollar. So basically they had $9,000 of contribution room they generated with $50,000. They've now doubled that to 18,000, which is fine. Now their total income goes from $100,000 down to essentially $82,000 is what it will show on their income tax. And they will get all of the tax back related to that last $18,000 that they took out of the corporation.
But the problem is they're still earning $82,000 instead of $50,000 each, which puts them in a tax bracket. A total tax is paid of $18,000, almost 19%. We're looking at an arbitrage here that's significant enough for these low spenders, where I don't actually think we want to go full throttle, take all this extra money out in order to just create the contribution room to make them feel like they've got a large RRSP or a larger RRSP over time.
I would say we want to be a little more conservative here. They can still fill whatever they're creating. Maybe even taking out slightly more out of the corporation to help them fill what is available to them every year, right? Maybe taking out 60 grand a year or 65 grand a year, somewhere around there, where they get to fill that 9,000 plus whatever additional room they've created in doing so. And that way they get a little bit of both worlds here without sacrificing too much taxes on the other 82 cents of every dollar that they're taking out here.
Jon Orr: So what's their alternative? Let's say they didn't think about doubling their salary or hadn't doubled their salary. Let's think about this long term for their retirement purposes. Is the move does it leave it in the corporation? Every dollar that you earn in income gets taxed at that low tax rate, 11.2% now instead of 12.2%?
Kyle Pearce: Yep, that change has gone into effect. So thanks for calling us out on that one for sure.
Jon Orr: So we got that and then because I'm earning low amounts, let's say I leave that money in there and then I want to then use it as my retirement fund. What are the benefits here to getting it out? Because that's their thinking. I'm just trying to wrap my mind around what they were thinking to double versus saying like if I leave it in the corp, it's on the corp side, not on the personal side.
But if I grow it in the corp, now there's passive income being generated and that's taxed heavily inside of a corp. And then when I want to pull those gains out, is there a play here that the RRSP still makes sense because of all of that?
Kyle Pearce: Yeah, I think it's definitely, and this is something that we do with all of our clients that we work with is we'll actually run the numbers. Like we won't base any decisions based purely on back of napkin math here.
But as a start, what we want to consider is that again, they're low spenders. So even if in the corporation we open up a margin account, for example, or any type of investment account in the corporation, it doesn't disqualify us from doing any type of passive income type investing. Because remember, if we create passive income in the corporation, the key is we just want to make sure we're not earning too much of it.
So again, the answer usually lies somewhere in the middle. It's not a earn zero passive income in your corporation or earn as much passive income in the corporation as possible. It's about finding the right balance based on your business and based on your lifestyle.
So imagine this world where they open up this margin account in their corporation and they aren't overproducing too many dividends, right? Because we don't want this pile to get so large that they start grinding away their small business tax rate. So that's a really important thing.
But let's say they were creating $20,000 of passive income inside of the corporation. And let's assume that it's truly qualified as passive income. It's not return of capital, which we'll get into in some other episodes. It's not any of the tax-free dividends coming from an operating company up to a holding company or anything like that. We're talking about true interest or dividend income that's coming to the corporation.
If we use $20,000 as an example, right off the top, they are going to pay about 50% in taxes, which we don't like to see. It goes down to 10,000. However, if they start paying themselves ineligible dividends, which that would be the qualifying number for them because they are under $500,000 of earning, they would actually get a tax credit back to the corporation so that they get part of that 50% refunded back to them. And then at a personal level, they will pay the difference based on their tax bracket.
Now there is a slight arbitrage, as we've mentioned in our recent episodes, especially for our Ontario friends, that the Ontario small business tax rate has gone down a percent. Seems like a celebration, but actually, when we go to take it out, it costs us more than a percent to get it back out. So there is an arbitrage that we're gonna lose in that transaction if all of our wealth is built up in this manner inside the corporation.
However, it's not going to guarantee them that they're going to have to pay 50% in tax. They'll likely pay somewhere around what they were going to pay anyway if they were taking salary or dividends. So I like this strategy of them utilizing the RRSP where it makes sense. They have some room. So let's use the room we have. Let's not try to fabricate extra room from year to year.
And with the leftover funds, we're going to invest inside the corporation. And, you know, if they're working with us, we're going to work out a strategy where they're not necessarily all in on dividends or they're not all in on cap gains or they're not all in on anyone's strategy. We're going to create a strategy where they have a nice, well-diversified portfolio that's going to suit their lifestyle.
And here's the other critical part. Some people worry about the small business tax rate. If you're earning a significant amount in your corporation and you're spending a significant amount as you head into retirement, the small business tax rate grind actually doesn't matter once you decide to stop earning active income.
So I want to pause there for a second because I don't think we've ever addressed this on the show. That grind down rule only matters while you are fully operating your business and earning active income. But if you're posting into retirement and you start to see your passive income is rising in the corporation and you're getting to the grind down where you start grinding it away, but you actually plan to stop earning active income in the business, it actually doesn't matter at all.
The key will be the planning around where what income we're taking from where to make sure that we utilize things like our grip account or like our refundable dividend tax on hands account, which is really, really critical so that we're not unnecessarily allowing our compounding rate to actually minimize or lag behind because we haven't taken advantage of the tax credits that we can each and every year as we move forward.
Jon Orr: Complex stuff. And I think this is my big takeaway is that it's always more than you think it is. So we've talked about a lot of different levers, a lot of different maneuvers, a lot of different kind of things that go into decision making, especially when we have the corporate side, personal side, and we're trying to navigate the nuance of trying to minimize tax, maximize returns, maximize gains, and try to make sure am I paying myself enough? Am I utilizing the registered accounts the right ways? There's a lot of nuance here.
And I think the big takeaway here is that there's always a middle ground here for your unique situation. There's not always a one side or the other. So if you've been listening like, I should always avoid RRSPs, then you know, if I'm making a lot of income each year and I have to pull a lot of income each year for my lifestyle or for whatever, you might say, well, I make a lot of money inside the corporation. There's not a I should just avoid all RRSP contributions in my contribution room.
And on the flip side, it shouldn't be like I should always try to max my RRSP contribution room. Like these people were trying to do. They're like, you know what? I should try to max this out. Let's pay ourselves more to max that out or to get really close to it. And instead, there's always this middle ground of nuance. And this is why we meet with individuals on a daily basis to help navigate the seams between corporate and personal strategies for wealth creation.
Kyle, what's your big takeaway here today?
Kyle Pearce: Yeah, I can't agree more, is like the answer always lies in the middle. And I guess the big takeaway for me, and I hope is one of the big takeaways for others who listen to the podcast, is that if you ever hear people who are against one thing or all in on one strategy, I would say you probably want to run, right? Because the reality is that everyone is different. And that means that certain things make sense at certain times.
So when you hear people and sometimes we'll put out a social post that highlights a very specific scenario that makes it look as though RRSPs are bad. And it's like, well, no, it's bad for that person in this way if they do certain things. So the example today is if you're a low-income earner, it's like to try to inflate your room just for RRSP contribution room or just to maximize CPP credits. I would say that that may not be the best move for you.
We didn't get into it today on the CPP side, but remember, like CPP for business owners, you have to pay both sides of it. So you get like half the pension, really, if you think about it, compared to the average individual T4 employee of an outside or an arm's length company. So there's a lot for us to navigate here together.
And this show isn't here for people to sort of take the information and necessarily feel like they can go out and do everything by themselves. There's going to be certain things that you do wanna do on your own and are comfortable to do on your own. But a lot of times just having a sounding board, having someone to sort of map things out with you and think things through is really important.
We're not here to tell you what to do, but to educate you to figure out where you find yourself in the middle. Because it's somewhere in the middle. We don't know. For you, John, it might be you're gonna lean more towards one side and I might lean more towards the other. And then you and I typically try to drag ourselves somewhere in between those two points so that you and I kind of go, Well, what if I'm wrong? What if he's wrong? Well, at least we're somewhere in the middle between those two perspectives. And we can always move that from year to year with good solid planning.
So if that sounds like you, if you're looking for an overview, you want to think things through based on your own situation or strategy, you should reach out to us. There's a link around this audio or video. You should definitely click on that link and see if you're a good fit to hop on a discovery call with us. We do full strategies on that call, try to teach you as much as you possibly need. And of course, on that call, you will not be tried to be sold on any one strategy, product or service. We are here to help you. And if implementation makes sense down the road, we're here to help you with that implementation.
