New Retirement Strategies for Small Business Owners

As a small business owner, you will often face a variety of challenges when planning for the future, such as having no stable income or company retirement plan. These challenges will affect whether you can live a comfortable life after you retire. To tackle these challenges, small business owners should plan early for their retirement. In this article, we will compare traditional and new retirement strategies to help you make the best investment choices.

Traditional Retirement Strategy

A small business owner usually doesn’t have a retirement plan offered by the company. Traditionally, he needs to withdraw money from his company and then invest in an RRSP, a TFSA or a non-registered account. This strategy is very easy to implement, but it has several shortcomings:

1. Investing in a TFSA

Even though your investments grow tax-free inside the TFSA, you still need to pay personal income tax when you withdraw money from your company.

2. Investing in an RRSP

An RRSP provides an income tax reduction when you withdraw money from your company. However, you will be taxed at the marginal rate when taking money out of your RRSP account. If your retirement income is too high, the withdrawal may also affect your Old Age Security (OAS) benefit.

3. Investing in a Non-registered account

If you have used all your RRSP and TFSA contribution room, then you have to put your investment into a non-registered account. There is no tax advantage to use a non-registered account. You will be taxed at the time you withdraw money from your company and taxed on returns from your investment.
In summary, traditional retirement strategies are not tax-efficient.

New Retirement Strategy

Is there a better way to prepare for your retirement? Of course! If you are healthy, we recommend that you invest in corporate-owned permanent life insurance. When you retire, you can use the policy to supplement your retirement income.

This strategy has many advantages:

1. There is no tax on insurance investment growth.
2. When you have passed away, some or all of the death benefits will be added to the capital dividend account (CDA). The best part of this strategy is that the proceeds distributed to shareholders from the CDA account are not subject to personal income tax.
3. For the death benefits that do not add to the CDA account, they will be taxed at a preferential tax rate.
4. This strategy will not cause a passive investment problem, so it will not affect your Small Business Deduction (SBD) limit.

Here are the steps:

Step 1: Use a company’s funds to purchase tax-exempt corporate-owned Participating Life Insurance or Universal Life Insurance.
Step 2: Wait patiently and let your investment grow.
Step 3: When you need to use the money for retirement, you can withdraw cash from the policy to the company and then distribute it as a dividend or use the company policy as collateral to borrow money from the bank. At the time of your death, the insurance proceeds will repay the outstanding loan balance. Any excess amount will be paid to your company.

Let’s look at the case below to see the advantages of this strategy:

Mr. Smith is the sole owner or key shareholder of a private company. He is in good health. His company is very profitable, and he has no plans to use these retained earnings for any specific purpose. However, his company does not have a registered retirement plan. He wants to plan early to ensure he can retire comfortably.

Let’s assume Mr. Smith:
1. 35 years old
2. Has a corporate investment tax rate of 50%
3. Has a shareholder dividend tax rate of 40%

He plans to use his corporate retained earnings to invest $26,975 a year for 20 years. Now, he has two investment options:
1. Investing in a million-dollar permanent life participating insurance policy
2. Investing in a GIC with a 2% annual interest rate

Which option is better? Let’s compare:

Assuming that Mr. Smith lives to 85 years old, he will invest $540,000 in total. If he invested all his money in a GIC, the investment would reach $970,000. When he passes away, his beneficiaries, however, could only receive $580,000 after tax. His tax liability for that investment would be $390,000.

If he invests all the money in a participating life insurance policy, his death benefit may reach 4.3 million, and his beneficiaries may receive the full benefit without paying any taxes. That’s seven times more than the GIC investment.

The following is a detailed strategy comparison:

If Mr. Smith does not need to use his policy to supplement his retirement income, he can choose to pass it on to his beneficiaries. But if he wants to withdraw some money from his company, he can:

1. Assigning the policy to a bank as collateral and borrowing funds when needed.
2. Accessing the cash value of the policy through a withdrawal.

1. Assigning the policy to a bank as collateral and borrowing funds when needed.

The gray area of the above graph is the cash value portion of the policy. As the investment grows, so does the cash value. At any time, Mr. Smith’s company can assign the policy to a bank as collateral for a line of credit and use the borrowed funds as he wishes. There are no strings attached. Banks are generally willing to lend up to 90% of the policy cash value to policyholders.

As you can see in the graph, when Mr. Smith turns 65, his policy cash value could reach 1.26 million. Then his company could borrow up to 1.13 million to use from a bank. When Mr. Smith turns 85, his policy may have a cash value of nearly 3.6 million. Then his company can borrow up to 3.24 million.

Through this retirement strategy, Mr. Smith’s company could potentially borrow at least $100,000 every year from his policy to fund his retirement until he passes away.  There is no restriction on the use of funds. Of course, if there is an urgent need, his company can borrow up to 90% of the cash value all at once.

2. Accessing the cash value of the policy through a withdrawal.

Mr. Smith’s company can simply withdraw cash or dividends from his policy if he wishes. But that might not be the best option. If his company borrows money directly from a bank, the policy is still largely intact and without any major changes. However, if he chooses to withdraw cash directly from his policy, this may incur both corporate and personal taxes. Moreover, if the withdrawal amount is too large, the death benefit may even decrease. As can be seen from the above graph, the policy value can grow rapidly, especially in the later stage. The cost of partially surrendering a policy might just be too high.

In Conclusion

As a small business owner, there’s no doubt running your business is both challenging and risky. But a coin has two sides. Challenges are often accompanied by opportunities. By owning a corporation, you also acquire a new financial tool that can significantly help you achieve your goals much faster. If you want to discuss your retirement strategy, please contact me at Apexlife.ca.

Disclaimer

All content on this site is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing in the site constitutes professional, legal, tax, investment, financial, insurance or other advice, nor does any information on the site constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. For more information, please visit ApexLife.ca.