The TFSA Should Not Be Overlooked by Incorporated Individuals with Long Time Horizons

When people have corporations it is common for them to retain all earnings in excess of their living expenses inside of their corporation to avoid paying personal tax. This seems logical. By leaving the money in the corporation there is more money to invest in the corporate investment account, and we know that about $50,000 of dividends can be taken out of a corporation nearly tax-free, making the idea of leaving everything in the corporation until it’s time to draw a conservative retirement income appear very attractive.

With the TFSA’s annual contribution room now sitting at $10,000 per year, we thought it was time to put this common logic to the test. Does it make sense for incorporated individuals to withdraw additional dividends in excess of their living expenses to contribute to the TFSA? To answer this question we modeled the total after-tax value of $1 of active small business corporation income in the personal hands of the individual. The individual can retain the $1 of excess earnings in the corporation, pay the 15.5% small business corporation tax, invest $0.845 in the corporate investment account, and eventually pay personal tax on the withdrawal of a dividend. Alternatively, they can pay small business corporation tax on the $1, take out a dividend (paying personal tax at 38.29%*), and invest $0.521 in the TFSA where there are no tax implications on an eventual withdrawal.

The results of the analysis are intuitive. While using  the TFSA involves taking a significant haircut upfront, all future growth will be tax-free. This means that the rate of growth in the TFSA will be higher than the after tax rate of growth of the corporate investment account. Given a long enough period of time, the TFSA will overcome its initial tax hit and surpass the after-tax value of the corporate investment account. The TFSA has no time restrictions, and can remain untouched to eventually pass to a beneficiary tax-free on the death of the individual – depending on the age and health of the owner, it can have a very, very long time horizon.

These issues are discussed in more detail, alongside similar analysis for the RRSP, in our recent whitepaper, A Taxing Decision.

Note that to maximize the $10,000 annual TFSA limit, the individual would need to start with $19,193.86 of excess earnings in the corporation.

*The examples discussed consider an individual with income between $150,000 and $220,000 in Ontario in 2015.

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