As a business owner in Canada, one of the most important decisions you'll face is how to pay yourself. The two primary methods of compensation are salary and dividends. Each has distinct tax implications, benefits, and drawbacks, and choosing the right mix depends on your individual circumstances. In this blog, we’ll explore the differences between salary and dividends, and discuss how to choose the best strategy for your business.
1. What Are Salary and Dividends?
Salary: A salary is a fixed, regular payment made to yourself as an employee of your corporation. It is treated as earned income and is subject to personal income tax. The company can deduct your salary as a business expense, reducing its taxable income.
Dividends: Dividends, on the other hand, are payments made to shareholders from the corporation's profits. These are not considered earned income, and thus, are not subject to Canada Pension Plan (CPP) contributions or Employment Insurance (EI). Dividends are taxed at a lower rate due to the dividend tax credit, but they are not deductible as a business expense.
2. Tax Implications
Salary: When you pay yourself a salary, it is considered employment income and taxed according to the marginal personal income tax rates. Salary payments reduce the corporation’s taxable income, which can lower corporate taxes. However, both the business and you as the owner must contribute to CPP, which can increase costs.
Dividends: Dividends are taxed at a lower rate than salary because they benefit from a dividend tax credit, which reduces the amount of tax you pay on this income. However, dividends do not reduce the corporation’s taxable income, and you are not required to contribute to CPP, which can be a cost-saving measure for business owners.
3. CPP Contributions
Salary: Paying yourself a salary requires both you and your corporation to contribute to the CPP, which adds to your overall cost. However, these contributions can provide you with future retirement income through CPP benefits.
Dividends: Dividends do not require CPP contributions. While this can save money in the short term, it also means that you will not be contributing to CPP, potentially impacting your retirement income. As a result, if you rely solely on dividends, you may need to create other retirement savings strategies, such as RRSPs or TFSAs.
4. Deductibility for the Corporation
Salary: Salaries paid to business owners or employees are fully deductible for the corporation, reducing the business’s taxable income. This can lead to lower corporate tax bills, making salary an attractive option for tax planning.
Dividends: Dividends are not tax-deductible for the corporation, as they are considered a distribution of after-tax profits. This means the corporation will still owe tax on the profits before distributing them as dividends to shareholders.
5. Impact on RRSP Contribution Room
Salary: One of the key benefits of paying yourself a salary is that it increases your Registered Retirement Savings Plan (RRSP) contribution room. RRSP contribution room is calculated as 18% of your earned income, up to an annual limit. A higher salary allows for more substantial RRSP contributions, giving you a tax-advantaged way to save for retirement.
Dividends: Dividends do not count as earned income and therefore do not generate RRSP contribution room. If you primarily rely on dividends for income, you may have limited opportunities to contribute to your RRSP.
6. Corporate Tax Considerations
Salary: Paying yourself a salary reduces the corporation’s taxable income, which can lower corporate taxes. The downside, however, is that both the corporation and the individual have to pay CPP contributions on that salary.
Dividends: Dividends are paid out of after-tax profits, so the corporation will have already paid its taxes before distributing dividends. This means there’s no immediate tax deduction for the corporation, but dividends may still be a tax-efficient way of compensating yourself due to the dividend tax credit.
7. Which is Better: Salary or Dividends?
There’s no one-size-fits-all answer. The decision between salary and dividends depends on several factors, including your income needs, tax situation, and retirement plans. Here’s a general breakdown:
Salary is better if:
You want to contribute to CPP and receive CPP benefits in retirement.
You want to maximize your RRSP contribution room.
You need a steady, predictable income stream.
Dividends are better if:
You want to reduce your CPP contributions and save on payroll taxes.
You don’t need a high level of RRSP contribution room.
You prefer to take advantage of the lower tax rates on dividends.
8. Combining Salary and Dividends
Many business owners choose a hybrid approach, paying themselves a combination of salary and dividends. This strategy allows you to benefit from the best of both worlds. By paying yourself enough salary to contribute to CPP and create RRSP contribution room, and then topping up with dividends for tax efficiency, you can strike a balance between immediate cash flow and long-term financial planning.
Conclusion
The choice between salary and dividends in Canada depends on various personal and business factors. Salary offers advantages in terms of CPP contributions and RRSP eligibility, while dividends provide tax efficiency and flexibility. Working with a tax advisor can help you determine the most tax-efficient strategy for your business, allowing you to maximize your income while minimizing your tax burden.
Key Takeaway: Salaries offer stability, tax deductions, and retirement benefits, while dividends provide tax savings and flexibility. Consider your long-term goals when deciding between the two, or explore a combination to optimize your compensation strategy.
Comments