What investments should you cash out first?
In most cases, you should start by cashing out any amounts you have loaned to the holding company (advances) and the amounts in your Capital Dividend Account (CDA).
Why should you start by cashing out advances?
Have you put your own personal money into your company? It's as if you loaned money to a close friend: when they pay you back, you won't have to pay any income tax. That's why you should cash it out first.
Why should you withdraw from your Capital Dividend Account (CDA) first?
A CDA is a purely fiscal account; it doesn't really contain any money. It's like an agreement with tax authorities on what amounts can be withdrawn without paying taxes. The amount in the CDA is calculated based on:
- The non-taxable portion of capital gains and losses
- CDA dividends received from another company
- The proceeds (or part of the proceeds, depending on age) received from a life insurance policy contracted by the business
- Gains and losses on the sale of certain fixed assets (such as real estate or equipment)
The main point to remember is that you won't pay taxes on CDA withdrawals, so it's a good idea to access this money first.
Next, should you pay yourself dividends or use your personal investments?
To reduce your income taxes, it's often more advantageous to withdraw your advances and CDA balance first, then your non-registered personal investments. Next, cash out other amounts held by your business (dividends), then finally your RRSP and TFSA. Read on to find out why.
In general, you should use these investments first (after your advances and CDA balance). Why? Because you won't pay any taxes except capital gains tax when you withdraw funds and there is no tax benefit to keeping them. However, in years where your revenue is much lower than usual, it may be worth it to take advantage of the low tax rates on the first few tax brackets. You may therefore consider withdrawing amounts from your company instead, then from your RRSP, for example.
RRSPs vs. dividends
Why should you draw down dividends before your RRSP and TFSA? Because you can get tax credits for dividends. This means that you'll get to keep more of your money if you withdraw dividends from your business than if you withdraw the same amount from your RRSP.
Another good reason to wait before you withdraw from an RRSP: income generated by investments in an RRSP is not taxable until withdrawal. Conversely, gains and income from a business are taxable. This means often you're better off not dipping into your RRSP right away.
Money earned in a Tax Free Savings Account (TFSA) is sheltered from taxes. Our recommendations are similar: don't start withdrawing from your TFSA right away and keep investing in as long as possible.
Should you start by receiving eligible or non-eligible dividends?
The most beneficial scenario involves receiving eligible dividends, since they are less heavily taxed. But to pay eligible dividends, the business must have a GRIP balance (we'll talk about that later).
The business can also pay you non-eligible dividends. In that case, you'll pay more income tax on the money you receive. This is because the income pool these dividends originate from was subject to a lower tax rate than the income pool that can be paid out as eligible dividends.
To recap: When a business pays higher taxes on an income pool, it can generate eligible dividends that are taxed at a lower rate after they are paid to shareholders. Conversely, when the business pays lower taxes on an income pool, it can generate non-eligible dividends that are taxed at a higher rate after they are paid.
What other fiscal accounts should you know about as an entrepreneur?
General Rate Income Pool (GRIP)
Like the Capital Dividend Account (CDA) discussed above, the GRIP is a purely fiscal account. It's an accounting entry, rather than a bank account with money in it.
Its value is calculated based on the portion of an active business's income that exceeds the business limit, which is generally $500,000. It can also be based on investment income paid as eligible dividends (often originating from large-cap equities).
As discussed above, the amount in the GRIP is used to pay dividends that are taxed at a more favourable rate (eligible dividends).
Pro tip: Take advantage of the GRIP if you can invest the amounts in a vehicle that provides tax benefits, such as an RRSP or TFSA. Otherwise, it's best to leave these amounts in the GRIP (if you don't need to use them).
Refundable Dividend Tax on Hand (RDTOH) account
An RDTOH is another type of notional fiscal account. Passive investment income earned by a business is subject to tax. To prevent this income from being taxed again when it's distributed to shareholders as dividends, it's recorded in the RDTOH account. The amount in this account represents income taxes paid that will be reimbursed when shareholders receive taxable dividends.
There are two types of RDTOH accounts: eligible and non-eligible. Two points you should be aware of:
- You should recover amounts in an eligible RTDOH account first. To do so, the business must pay you an eligible dividend from its GRIP balance.
- Then, if the GRIP balance is at zero, the business can pay you non-eligible dividends so you can continue to recover amounts in both accounts. Important point: Non-eligible dividends should first be used to empty the non-eligible RDTOH account.
What about paying off your debts?
There are often tax benefits to having a good strategy for drawing down amounts invested in a holding company for your retirement. However, if you have personal debt, it may be a good idea to withdraw some funds to pay it off. You'll need to consider rates of return, the nature of your investments, how much time you have ahead of you and whether your business has fiscal accounts (CDA, GRIP and RDTOH). You should also discuss the following two questions with a specialist to help you make the right decisions:
- What's the interest rate on your personal debt?
- Are your debts tax deductible?
Very few people truly understand all the ins and outs of accounting
and tax planning for their business or holding company. That's
completely normal: you're focused on the challenges of running your
business every day. So when you start planning how you'll draw down
investments from your holding company for retirement, ask for advice
from a specialist. Just like in business, every situation is
unique and your strategy should be tailored to your needs. We're here
to answer your questions.