By Jason Yee
Greater opportunity awaits the business owner who views their personal wealth from a kaizen perspective – from a continuous improvement point of view.
If you’re deciding whether to retain business income in your corporation or invest it personally, our holistic analysis reveals an easily overlooked opportunity. We apply two continuous improvement principles to show how the powerful business practice of kaizen can benefit your wealth planning:
- The value stream approach, with a more holistic performance measurement
- Identification and elimination of waste
If you have more profit from your business than you need for lifestyle expenses and for reinvestment in the business to sustain or expand operations, you have excess business income. It can be more tax-efficient to invest that excess in your personal Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA) than to hold financial assets in a corporate investment account. Once enlightened by the results, you can shed the newly revealed waste inherent in the conventional approach. It’s time to discover your “hidden factory” of wealth.
Consider two managers you’ve hired to run respective departments in your business. You have instructed both to maximize profitability. This would be simple if the actions of one manager did not affect the results of the other. But business owners know that’s not the case. Not only do the actions of one manager affect the results of the other, unchecked they can lead to suboptimization2 – that’s when you improve one area of something but ignore how those changes influence other components.
This situation is similar to deciding whether to invest within your corporation or to receive that business income and invest it personally. It is similar because you can gauge each of these options by their standalone performance indicators, such as the amount of tax paid in any single year, or you can examine how they influence each other and produce a more strategic key performance indicator (KPI). Often, annual tax minimization is viewed as a victory. But as we’ll demonstrate, it can be suboptimal from the point of view of your overall final wealth. Our KPI is your final level of after-tax wealth at the time when you need it – your actual spendable dollars. Money in your hands at retirement is an example.
But corporate tax is lower. What have I missed?
Conventional wisdom has often been to leave excess business income inside the corporation. These are some of the features of this strategy:
- More money is available to invest at the starting point because no personal tax is paid.
- Payment of personal tax is deferred by leaving money in the company.
- The money will be taxed at the lower dividend rate when it is eventually withdrawn.
When the analysis stops here, the conventional approach is correct, if the comparison personal investment is in a non-registered account. Such a comparison ignores registered investments, which are critical parts of your value stream.
Taking the analysis one step further, we considered registered investment accounts such as RRSPs or TFSAs. We found that investing personally starts to outperform investing within a corporation after about 15 years. The outperformance from investing personally increases the longer you hold the investments.
Gemba is a Japanese word meaning the “real place,” or the place where work actually occurs.
To many, the idea that personal investing could outperform corporate investing is contrary to conventional wisdom.
To understand the real issues and learn the details it is critical to go to the gemba to see what’s happening. This is our way of saying we’re going to take a look under the hood.
To learn the wisdom of outperforming through the coordination of your personal and corporate investing, download the discussion paper “Going to the Gemba”.
I’m curious. How does it work?
This strategy works because the after-tax rate of return is actually lower when the investment is held in your corporation! This is the part where we pause because it can be counterintuitive. Two key factors come into play.
The first factor is that the investment return from a globally diversified portfolio of stocks and bonds comes from a few different sources: interest, dividends, and capital gains. A portion of the capital gains are realized each year as individual positions (investments) are sold as part of regular portfolio management and rebalancing. Some capital gains remain unrealized and are reflected in increases in the price of the individual positions that are held.
Tax must be paid annually on all interest, dividends, and realized capital gains when investments are held within the corporation. This means there is a constant loss of tax deferral – there is “tax waste.” This is because corporate accounts are non-registered. The only source of investment return that is truly deferred in a corporate account is the unrealized capital gains. The overall effect is a lower after-tax rate of return.
Registered investments do not have annual tax waste that grinds away a portion of their rate of return. 100% of all investment return remains fully tax-deferred in an RRSP. Returns are tax-free in a TFSA. This means identical investments in an RRSP or a TFSA grow faster than those in a corporate account.
The second factor is tax integration. Integration is the concept that the final amount received by a business owner should be the same whether it came from the payment of salary or dividends.
Accounting for integration is necessary to make the comparison between corporate and personal investing truly apples-to-apples. Accounting for integration means we consider all the comparison investments on a fully distributed basis. It addresses features of the conventional wisdom approach such as having a higher investment starting point when personal tax doesn’t have to be paid up front, and the lower dividend tax rate. We’ll spare you the technical tax treatment of integration and get to the results.
Show me the proof!
Our KPI is the after-tax dollars in your hands for each dollar of business income invested.
Personal registered investments start to outperform corporate account investments after about 15 years. The increasing spread from corporate account investments is illustrated in the graph and accompanying table. This spread is the amount of waste that can be eliminated. It is the opportunity available for capture.
“The Fabulous Saskatchewan Advantage”
The TFSA is often quickly dismissed when compared with other investment vehicles available to business owners. This is because all personal tax must be paid up front, so it has the lowest initial investment amount. Yet we find that TFSAs can slowly start to outperform even RRSPs, particularly after about 25 years. What’s going on here?
There is a very small failure to achieve perfect integration in Saskatchewan. This is because of the combination of our small business and non-eligible dividend tax rates compared with the highest marginal personal tax rate. The difference is 0.6%. TFSA could stand for The Fabulous Saskatchewan Advantage!
When the goal is to maximize your overall long-term wealth, business owners have additional machines in their personal wealth factory. Cooperation between your corporate tax planning and personal investing can reveal new tax efficiencies that increase your wealth.
1 Adapted from TKMG Inc. website. https://tkmg.com/lean-terminology
2 Karen Martin and Mike Osterling. Value Stream Mapping, 1st ed. McGraw-Hill Education, 2014.
3 Benjamin Felix. A Taxing Decision: Determining the Worth of Registered Accounts for Owners of Small Business Corporations, white paper. PWL Capital, 2017.
First published in the September 2020 edition of The Business Advisor.