Clearing the confusion - some timely tips for saving for retirement as a business owner

Let’s be real here. Planning for retirement as an entrepreneur who owns a small business in Canada can be hard! Actually, being candid, with the demise of most defined benefit pension plans amid corporate cost cutting, saving enough for retirement can be a challenge for most Canadians these days!

But there is no doubt that it’s a special challenge for those who own their own business!

For many, the early years when there is a long runway to retirement is also the time when the business is hoovering up money as investment is needed to get it off the ground and then to grow it to scale. Many entrepreneurs who I have worked with lament that in those start up years, they barely have enough funds for their current needs - forget about putting some away for the future.

And even those who have managed to contribute to their retirement plans, can find themselves in the position of having to draw the money out due to the cash flow needs of the business. (Everyone who is reading can likely relate to the situation where they need capital to execute on the first or next level of their business vision but have to come up with the funds personally because the bank just doesn’t see the same potential for the future or enough of the boxes on their spreadsheet did not get ticked!)

So what’s the best approach for an entrepreneur to save for the future?

First, a word of caution. There is no one “best” approach. This discussion contains general information that can help you (and your advisors) decide what’ your “best” approach given your unique circumstances. Make sure that you are working with qualified professionals to optimize your personal retirement situation.

The RRSP vs. TFSA quandary

While I’m writing this less than a week before the deadline for RRSP contributions to count for the prior taxation year, planning for retirement and considering your options should not be a last minute decision. So even if you’re reading this blog in April or July or November, keep going! These tips apply all year long. (Although I know that sometimes when the year end statements for the business are put together and end up being better than expected, many a business owner has run to top up that RRSP to cushion the tax “blow” of a great year!)

First, let’s consider the RRSP pros and cons

In general, if you expect your marginal tax rate to be lower in retirement than it is in the current taxation year, this would favour making your contribution to an RRSP. That’s because all contributions made to your RRSP (or a spousal RRSO which we touch on below) are deductible from the current year’s taxable income.  

Any contribution made between January 1st of the tax year through March 1st (or February 29th in a leap year) of the following year that hasn’t been deducted previously can be applied against all sources of income - bringing down your tax payable and your overall effective tax rate.

While the amount of RRSP contribution that you’re entitled to make is based on 18% of the prior year’s earned income (up to a limit which changes each year), the contribution itself can be written off against all sources of income.

RRSPs also have a specific timetable to be withdrawn.  By December 31st of the year that you turn 71, all funds in your RRSP have to be transferred to a registered retirement investment fund (RRIF) or an annuity. If this doesn’t happen, the entire balance of your RRSP has to be included in income for the year. Talk about a major OUCH!

Once the funds are in the RRIF or annuity, there is a prescribed minimum amount that has to be withdrawn each year until the entire fund has been disbursed (which under new rules does not have a specific age for termination).

And here, in my experience, is where taxpayers can run into unanticipated consequences.

Picture the entrepreneur who has successfully exited their business to start their retirement (ie. sold for a significant sum of money). They will likely have income from the invested funds of the sale.

I have seen the scenario where the RRIF income combined with current earnings in retirement - CPP, OAS, RRIF, interest, dividends, capital gains … - lead to the result that our entrepreneur is still in the higher tax brackets. And on top of the high rate, may experience the clawback (i.e. required repayment) of government benefits such as the Old Age Security).  Currently, I have four clients who find themselves in this scenario and at least two of them have indicated that they wish that all of their savings were tax paid. They psychologically don’t like having large tax payable balances in retirement or having to tax effect the funds that they have in their investment accounts.

So when contributing to your RRSP as a small business owner, be aware that future tax rates may increase, clawback thresholds may change, you may still be earning a high level of income.

Despite that, you will have had all of the years between contribution and withdrawal - which can easily be decades - where the tax on that money has been deferred and has compounded without tax impact.  This is a significant benefit for most! And one that’s easily forgotten when making your quarterly instalments during your retirement years.

Now let’s think about the TFSA

First, it is important to note that the TFSA may have been given a less than accurate name back in 2008 when the program was announced.  While many people are confused about this point, the TFSA is far more than a traditional “savings account” at your local bank or credit union.

This confusion may be why only slightly more than half of all Canadians even have a TFSA.  They see the advertisements for 2% interest on TFSAs that the banks put out for cash deposits and think “At that rate of return, why bother?”

But the reality is, almost any investment that can be held in an RRSP can also be held in a TFSA - cash, bonds, mutual funds, individual stocks, exchange traded funds (ETFs) and even options.

One of the most fundamental differences between an RRSP and a TFSA (which stands for Tax Free Savings Account) is that contributions to a TFSA are not deductible for tax purposes - so it is after tax money that is being invested.

If you are in a lower tax bracket currently (perhaps because your business is still in the start up phase) and you expect to be in a higher tax bracket when you retire, this would favour prioritizing a TFSA contribution in the current year.

Another point to consider is that TFSAs are not just for retirement. They are also useful for accumulating an emergency fund or saving for a home or child’s education. Unlike RRSPs, if you withdraw money from a TFSA, the following tax year you get that contribution limit back and can effectively refill your plan.

This makes the TFSA a preferred choice for business owners who think that they may need to access the funds that they’ve put away before retirement (say to deal with a serious cash flow crunch in the business).

Additionally, since withdrawals of TFSA funds do not have to be reported for tax purposes, if you expect to be in a higher tax bracket at retirement, you don’t have to worry that withdrawals from the plan will cause your government benefits (primarily Old Age Security) to be clawed back.

Because of these flexibilities, having a TFSA can be helpful for those small business owners who plan to retire early - withdrawing funds from their TFSA while leaving their RRSPs alone until later years.

In the same vein, you can also continue to contribute to your TFSA to any age (in comparison to RRSPs which become unavailable for additional contributions past the end of the year that you become 71 years old).

The best of both worlds

Of course, it does not just have to be one or the other - RRSP or TFSA - and for many small business owners the best solution will be a combination of the two savings vehicles. This is particularly true for those who are in the mid tax brackets for a given taxation year (generally between $47,000 and $95,000 in net income).

RRSP limits for a year are based on 18% of your earned income for the prior taxation year. For 2021, this is up to a maximum of $27,830. Unused contributions can be carried forward to future tax years - but once a contribution is made, if the funds are withdrawn before maturity, you do not get that contribution room back.

TFSA limits are significantly lower for most taxpayers - those earning more than $33,333 in earned income - as they are capped at $6,000 per year currently. Like an RRSP, the limits do carry forward to future years if unused. And any amounts withdrawn are added back to your limit the next taxation year.

For both RRSPs and TFSAs, it is important not to over-contribute as this can result in significant penalties.  The best way to keep track of what your available limit is for either vehicle is to check your prior year’s Notice of Assessment (or Reassessment, if applicable).  The balances are also both available in the My Account portal on the CRA website.

Some concluding thoughts

Retirement may seem far off and you may feel that you have more pressing issues to deal with - like meeting payroll or paying for that new critical software to run your business. But regardless, having a plan for saving for the future and sticking to it (to the best of your ability) is really a gift that you can give to your future self!

In a prefect world, you would maximize contributions to both your RRSP and TFSA every year.  But given that that’s not possible for many Canadian entrepreneurs, making regular, manageable weekly or monthly contributions and using the funds (especially in your RRSP) only as a last resort is a good start.

Remember that even a small amount contributed regularly will add up over the years and give you a foundation to build from when your business has grown to scale and is enabling you to live the life that you desire - both currently and through your retirement years! And in the meantime, not having to scramble (or borrow) funds to put in your plan right before the deadline, allows for much needed stress reduction in the life of a busy entrepreneur!

For more information and resources for Canadian entrepreneurs, sign up for our email newsletter below.

And join the Compass membership site - a hub of invaluable resources and community exclusively for Canadian entrepreneurs which launches in March 2021. You can get on the list at marilynjcrowley.com/compass (or on the main menu on the home page).

Leave a comment below and let me know what approach you’re taking to retirement planning.