Dividends vs Salary: Which way should I pay myself as a Canadian entrepreneur?
Are you a Canadian entrepreneur wondering how to pay yourself? When it comes to compensating yourself as a business owner, the options are usually between dividends and salary. Each method has its own advantages and disadvantages, so it’s important to understand the basics before making a decision. In this article, we’ll delve into the differences between salary and dividends and explore the tax implications of each. We’ll also discuss the pros and cons of paying yourself a salary versus dividends and the factors you should consider when choosing between the two options.
Understanding the Basics: Salary and Dividends
When it comes to managing your finances as a business owner, it’s important to understand the difference between salary and dividends. These two forms of compensation offer different benefits and considerations. Let’s take a closer look at each.
What is a Salary?
A salary is a fixed amount of money paid to an employee periodically, typically on a monthly or biweekly basis. It serves as a regular income for individuals who work for a company, including business owners who register themselves as employees of their own company.
When you pay yourself a salary, you are essentially treating yourself as an employee, which means deducting the appropriate income taxes, Canadian Pension Plan (CPP) contributions, and Employment Insurance (EI) premiums from your earnings, just like any other employee. By doing so, you ensure that you are contributing to your retirement savings through CPP and protecting yourself with EI coverage in case of unforeseen circumstances.
One advantage of paying yourself a salary is that it provides a consistent and predictable income stream. This can be particularly helpful for managing your budget, as you know exactly how much money you will receive each pay period.
What are Dividends?
In contrast to salaries, dividends are payments made to shareholders based on the profits of a corporation. If your business is set up as a corporation, you have the option to pay yourself dividends as a form of compensation.
Unlike salaries, dividends are not subject to income taxes, Canadian Pension Plan contributions, or Employment Insurance premiums at the time they are paid. However, it’s important to note that the corporation paying the dividends is still responsible for corporate income taxes on its profits. As a shareholder, you will also need to report and pay taxes on the dividends you receive on your personal tax return.
One advantage of receiving dividends is the potential for tax savings. Since dividends are taxed at a lower rate than regular income, you may be able to reduce your overall tax liability by taking a portion of your compensation in the form of dividends.
It’s important to consult with a tax professional or financial advisor to determine the most appropriate compensation structure for your specific situation. They can help you navigate the complexities of salary and dividend payments, ensuring that you are maximizing your income while also meeting your tax obligations.
In conclusion, understanding the basics of salary and dividends is crucial for business owners. By knowing the differences and benefits of each, you can make informed decisions about how to compensate yourself and manage your finances effectively.
The Tax Implications of Salary and Dividends
Taxation on Salary in Canada
When you pay yourself a salary, it is considered employment income and is subject to federal and provincial income taxes. This means that a portion of your hard-earned money goes towards funding government programs and services. The amount of tax you pay on your salary depends on your income level and the tax brackets set by the government. It’s important to note that the tax rates can vary between federal and provincial levels, so it’s essential to understand the specific tax regulations in your province.
|Max. Provincial Income Tax
|Max. Provincial + Federal
|Newfoundland and Labrador
|Prince Edward Island
Additionally, when you pay yourself a salary, you must contribute to the Canada Pension Plan (CPP) and Employment Insurance (EI). These contributions are mandatory and are deducted directly from your salary. While these deductions reduce your take-home pay, they also provide you with certain benefits. For example, contributing to your CPP account can increase your future retirement benefits, ensuring financial security during your golden years.
Moreover, paying yourself a salary has other advantages. It allows you to establish a clear employer-employee relationship within your corporation, which can be beneficial for legal and liability purposes. It also provides you with a consistent and predictable income stream, making it easier to manage your personal finances and plan for the future.
To pay less income tax in Canada, individuals can consider various strategies. These may include maximizing contributions to Registered Retirement Savings Plans (RRSPs), utilizing tax deductions and credits, investing in tax-efficient vehicles like Tax-Free Savings Accounts (TFSAs), or exploring income-splitting opportunities with family members.
Taxation on Dividends in Canada
In Canada, dividends are subject to a lower tax rate compared to employment income. This is because corporations pay taxes on their profits before distributing dividends to shareholders.
Pros and Cons of Paying Yourself a Salary
Benefits of a Salary
One of the significant benefits of paying yourself a salary is that you contribute to Canada Pension Plan (CPP) and Employment Insurance (EI), which can provide you with future retirement benefits and unemployment insurance. By consistently paying yourself a salary, you are actively investing in your own financial security, and you can use our retirement planning calculator to see the real benefits of making regular retirement contributions.
Contributing to CPP ensures that you will receive a stable income during your retirement years. This government pension plan is designed to provide you with a portion of your average earnings throughout your working life. By paying yourself a salary and contributing to CPP, you are building a safety net for your future.
Similarly, paying into EI can provide you with a safety net in case of unexpected job loss. If you find yourself unemployed, EI benefits can help cover your living expenses while you search for a new job. By paying yourself a salary, you are actively protecting yourself against unforeseen circumstances.
Additionally, having a salary can make it easier for you to demonstrate a stable income when applying for a mortgage or other forms of credit. Lenders often look for consistent income streams to ensure that borrowers can meet their financial obligations. By receiving a regular salary, you can provide lenders with the reassurance they need to approve your loan.
Another benefit of a salary is that your CCP and EI contributions cannot be ceased in case your business goes through a bankruptcy. This means that your pension is secure and that you have EI to protect you in case of unforeseen circumstances.
Drawbacks of a Salary
While a salary can offer stability and security, it may also come with higher tax obligations. As an employee, you are subject to both income taxes and CPP/EI contributions, which can reduce your take-home pay. This means that a portion of your salary goes towards funding government programs and services.
Furthermore, although a salary may result in a lower take-home pay compared to other methods of compensation, it provides you with the peace of mind that comes with contributing to CPP and EI. By paying into these programs, you are investing in your future financial security and protecting yourself against unforeseen circumstances.
Pros and Cons of Paying Yourself Dividends
Benefits of Dividends
One of the main advantages of paying yourself dividends is the lower tax rate. By receiving dividends, you can potentially reduce your overall tax liability compared to receiving a salary. Dividends also offer flexibility, as you can distribute them based on your corporation’s profitability. This can be especially beneficial during challenging financial periods when your company’s profits may be lower.
Drawbacks of Dividends
One of the significant drawbacks of paying yourself dividends is the potential limitation on contributing to CPP. If your main source of income is dividends, you may not be able to make CPP contributions, resulting in reduced future CPP benefits. This can have implications for your retirement planning, as CPP benefits play a crucial role in providing a stable income during your golden years.
However, you can still make contributions to your Registered Retirement Savings Plan (RRSP), meaning that the CPP and EI are not the only protections you have as an entrepreneur.
Another drawback to consider is the potential impact on your personal creditworthiness. When applying for personal loans, lenders often assess your income stability and ability to repay. If your income primarily consists of dividends, which can vary, it may be more challenging to demonstrate a consistent income stream. This could potentially affect your eligibility for certain types of financing or result in less favorable terms.
Factors to Consider When Choosing Between Salary and Dividends
Your Business’s Profitability
The profitability of your business is a crucial factor to consider when deciding between salary and dividends. If your company consistently generates significant profits, paying yourself dividends may be a tax-efficient option. However, if your business experiences fluctuating profits or is in its early stages, a salary may provide more stability.
Your Personal Financial Situation
Another important consideration is your personal financial situation. If you have immediate financial obligations or require a consistent income, a salary may be the better choice. On the other hand, if you have other sources of income or have a long-term financial plan in place, paying yourself dividends might be more advantageous.
Your Future Business Plans
Lastly, your future business plans should also influence your decision. If you intend to grow your business or seek external funding, having a salary can help demonstrate stability and financial responsibility to potential investors or lenders. On the other hand, if you plan to continue as a self-sustaining business with minimal external funding, dividends may offer more flexibility.
However, we know that business growth rarely follows a straight line. It begins with a simple idea and a business loan, but eventually, it can evolve into a thriving company with multiple employees.
Registering a business in Canada can be quite a cumbersome process. Not only do you need to determine the most suitable business structure for your needs, but you also have to navigate through a mountain of paperwork and bureaucratic procedures. While you can certainly choose to do all of this yourself, there are also services that can help you register your business in Canada for a low cost.
Dividends vs Salary: The Bottom Line
In conclusion, deciding whether to pay yourself a salary or dividends as a Canadian entrepreneur involves careful consideration of various factors. Both options have advantages and disadvantages to weigh against your business’s profitability, personal financial situation, and future plans.
It’s recommended to consult with a knowledgeable accountant or tax professional who can guide you based on your specific circumstances. Remember, the right choice for one entrepreneur may not be the best option for another. Ultimately, the way you pay yourself should align with your goals and priorities as a business owner.