The Salary Versus Dividend Conversation
For entrepreneurs who choose to incorporate, one of the most critical financial decisions is determining how to compensate themselves properly. Should they take a regular salary, or opt for dividends, or perhaps a combination of both? This choice has significant implications for both the business and the owner's personal finances, touching everything from taxes and retirement planning to access to credit and government benefits.
Understanding the Basics
Let's break down the core difference between paying yourself a salary and taking dividends. Think of salary as becoming an employee of your own business. You get a regular paycheck, just like anyone else on staff. The beauty of this is that your company can deduct this salary as a business expense, shrinking its taxable income. The flip side? You, personally, will be taxed on that salary as income.
Dividends, however, are a different beast. They're a slice of your company's after-tax profits distributed to its shareholders – which, of course, includes you. Because these profits have already been taxed at the corporate level, dividends aren't considered a business expense and don't reduce your company's taxable income. The good news is they're usually taxed at a lower personal rate, thanks to the dividend tax credit, a mechanism designed to avoid double taxation.
Pros and Cons: A Closer Look
Salary:
Pros:
Predictable Income: A regular salary provides a stable and predictable income stream, making budgeting and financial planning easier.
CPP Contributions: Salary income allows you to contribute to the Canada Pension Plan (CPP), which provides retirement, disability, and survivor benefits.
RRSP Contribution Room: Only employment income (i.e., salary) allows you to contribute to a Registered Retirement Savings Plan (RRSP), a key tool for retirement savings and tax deferral.
Easier Loan Approvals: Lenders often prefer a steady salary over fluctuating dividend payments when assessing loan applications.
Tax Deductible for the Business: Salaries reduce your company's taxable income, lowering corporate taxes.
Cons:
Higher Personal Tax Rate: Salary is taxed at personal income tax rates, which are often higher than dividend tax rates.
Depending on the province, this may not be true due to integration. See the “Integration Factor” below.
Dividends:
Pros:
Lower Tax Rate: Dividends are typically taxed at a lower rate than salaries due to the dividend tax credit.
No CPP Contributions Required: You don't have to make CPP contributions on dividend income, which means more money in your pocket now.
Cons:
No RRSP Contribution Room: Dividends don't generate RRSP contribution room, limiting your ability to save for retirement on a tax-deferred basis.
No CPP or EI Benefits: You won't be eligible for CPP benefits or Employment Insurance (EI) if you rely solely on dividends.
Double Taxation Risk: Your company pays corporate tax before distributing dividends, and you then pay personal tax on the dividends, leading to potential double taxation.
More Complex Tax Planning: Different dividend types (eligible vs. non-eligible) have different tax implications, requiring careful tax planning.
The Integration Factor
In Canada, the tax system is designed to "integrate" corporate and personal taxes. This means that, in theory, the combined tax burden on salary and dividends should be roughly the same. However, in practice, the actual tax impact can vary depending on your specific circumstances, such as your income level, province of residence, and the type of dividends you receive.
Finding the Right Balance
For many business owners, the optimal approach is to take a combination of salary and dividends. This allows them to balance tax efficiency with retirement savings and access to government benefits. A common strategy is to:
Take enough salary to maximize RRSP contribution room and CPP contributions.
Use dividends to supplement income while keeping personal taxes lower.
Making the Decision
Ultimately, the best way to compensate yourself depends on your individual needs and priorities. Consider the following factors:
Your income level and tax bracket: If you're in a high tax bracket, dividends may be more tax-efficient.
Your retirement goals: If you want to maximize your retirement savings, a salary may be necessary to generate RRSP contribution room.
Your need for government benefits: If you want to be eligible for CPP and EI, you'll need to take a salary. Remember, no one plans to have the worst happen to them. Those who do though, often are the most successful!
Don't navigate this financial maze alone. A qualified financial advisor or tax professional can be your guide, analyzing your unique circumstances and crafting a compensation strategy tailored to your needs. They'll illuminate the tax implications of both salary and dividends, ensuring you optimize your income and make the most informed decisions.
Reach out today to discuss how this impacts your financial plans for the future!
