Put your retained earnings to work
Tax Managed Strategy 11
Many business owners have built up significant retained earnings in their corporation and are looking for ways to withdraw them. If you’re a business owner looking to extract retained earnings out of your company, there’s a strategy available to you.
Retained earnings are a mixed blessing for business owners. On one hand, they represent the company’s success and profitability. On the other hand, it can be a challenge to take those earnings out of the business without incurring a large tax bill.
There’s a simple strategy that moves earnings out of the company and puts them to work, generating investment returns in a tax-efficient way. The strategy involves taking out an investment loan and using withdrawals from the corporation to pay the interest on the loan. The interest payments are generally tax deductible1 and allow business owners to withdraw an equivalent amount from their firms without any net tax consequence.2 At the same time, business owners now have the potential to significantly increase the value of their non-registered investment portfolio over the long term, as they have a large lump-sum amount invested that takes advantage of the benefits of compounding.
Furthermore, investing in a segregated fund contract can provide business owners with the potential to safeguard their portfolio from creditors, thereby helping protect their capital and potentially enable them to avoid estate fees while diversifying their investments.
Consider the tax consequences of having a corporation fund a $250,000 personal investment
Traditional method of taking money from a business
Pre-tax withdrawal from retained earnings |
$500,000 |
Subtract taxes paid at 50% |
-$250,000 |
Net asset available for investment |
$250,000 |
Tax Paid |
$250,000 |
Amounts and calculations are for illustration purposes only.
Looking at a leverage strategy
Net asset available for investments |
$250,000 |
Annual withdrawal from retained earnings to service interest-only loan |
$12,500 |
Interest deduction |
$12,500 |
Tax Paid |
$0 |
Amounts and calculations are for illustration purposes only.
Here's how it works, step by step
Step 1
Take out an investment loan.
Step 2
The amount of the loan is applied in a lump sum to purchase non-registered assets.
Step 3
The corporation pays the business owner an amount as salary or bonus equal to the interest on the leveraged loan. This amount is considered as part of the business owner’s personal income.
Step 4
The business owner may be able to deduct the interest payments at your marginal tax rate.
The outcome is that business owners can use an investment loan to invest in a non-registered investment. Meanwhile, they can also use payments from their companies to fund interest payments. These interest payments may be tax-deductible and offset the amount that was filed as personal income, allowing business owners to take money out of the corporation without paying any additional tax.
It’s a simple strategy that can make a big difference to the bottom line.
How far ahead could you be? – a case study
Jeremy, age 45, is a business owner. He takes out a $250,000 investment loan and invests the proceeds in a segregated fund contract.
Assumptions
Total loan amount |
$250,000 | Annual investment fund rate of return | 6% |
Loan interest rate |
5% | Annual taxable portion of fund return | 25% |
Marginal tax rate |
50% | Tax rate on income allocations | 25% |
What it looks like at year 10
After 10 years, assuming an average annual compound return of 6%, the leveraged account has grown in value to $447,712. After repaying the loan, the after-tax value of the account is $160,641.
Using this leverage strategy, the business owner’s personal net worth can be enhanced without having to pay tax on the withdrawal of retained earnings from the company.
Ideal candidates
- Business owners who’ve built up significant retained earnings within their corporation that they would like to withdraw in a tax-efficient manner and increase the value of their personal assets.
Take action
Consider:
- the amount of retained earnings you would like to pull out of the corporation
- using payments from the company to fund tax-deductible interest expenses on an investment loan.
Investment options with Manulife
Segregated fund contracts combine the growth potential offered by a broad range of investment funds with the unique wealth protection features of an insurance contract. Through Manulife segregated fund contracts, investors can help minimize their exposure to risk through income, death, and maturity guarantees; potential creditor protection features; and estate planning benefits—all from a single product or insurance contract.
Mutual funds can help meet your specific financial needs throughout your life. Whether you’re just starting out, accumulating wealth, or nearing/in retirement, mutual funds offered by Manulife Investment Management can provide you with solutions to help build a portfolio that meets your needs. Manulife Investment Management is committed to providing quality investment products and services so you can enjoy life and worry less.
Manulife Bank investment loans allow investors to make a large initial investment contribution and benefit from the potential for compound growth and interest deductibility. These loans are available for a variety of Manulife mutual fund accounts and segregated fund contracts, and offer attractive options such as 100% financing, no margin-calls on market fluctuations,3 interest-only payments, and a one-step application process.
1 Actual tax deductibility of loan interest depends on a number of factors, with the Income Tax Act (Canada) providing the framework for determining deductibility. Individual tax situations and tax deductibility will vary. Results for Quebec residents may differ due to different deductibility rules. Clients should consult their own tax and legal advisors with respect to individual circumstances. 2 The funds withdrawn must be paid to the business owner as salary or bonus, not directly to the lending institution. The corporation shouldn’t guarantee the loan or provide security for the loan as this may have adverse tax consequences. Retained earnings can be paid out as dividends, which have different tax implications that will affect the tax consequences and results of this strategy. Withholding tax on a withdrawal from the company can be reduced by filing form T1213, “Request to Reduce Tax Deductions at Source.” 3 Manulife Bank will not trigger a margin call in cases where the security pledged is guaranteed. For loans $1,000,000 and less, there is no margin call. However, if the LTV exceeds 125% of the investments value Manulife Bank at its sole discretion can convert the loan payments to Principal plus Interest. The loan would then be repayable in equal monthly Principal payments plus Interest, amortized over a maximum 20-year term. After three (3) consecutive monthly payments, if the LTV has reduced to 100%, the borrower may request, subject to approval from Manulife Bank, that the loan revert to the original repayment plan. For loans greater than $1,000,000 a margin call is triggered at 85% and must be returned to 75% immediately. If margin is not met, demand for payment is issued and full redemption is processed. Any shortfalls are the borrower’s responsibility.
Important disclosure
Borrowing to invest may be appropriate only for investors with a higher risk tolerance. You should be fully aware of the risks and benefits associated with investment loans since losses as well as gains may be magnified. Preferred candidates are those willing to invest for the long term and not averse to increased risk. The value of your investment will vary and is not guaranteed; however, you must meet the loan and income tax obligations and repay the loan in full. Please ensure you read the terms of the loan agreement and the investment details for important information. Manulife Bank of Canada solely acts in the capacity of lender and loan administrator and does not provide investment advice of any nature to individuals or advisors. The dealer and advisor are responsible for determining the appropriateness of investments for their clients and informing them of the risks associated with borrowing to invest.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.
Any amount that is allocated to a segregated fund is invested at the risk of the contract holder and may increase or decrease in value.
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