Source: Russell Investments
Investing profits is a powerful wealth accumulation tool for Canadian small business owners, but business owners often fail to consider the impact of taxes on investment returns. Failing to account for tax is also one of the biggest mistakes financial advisors and do-it-yourself investors make. Tax drag, also known as the “silent thief,” refers to the reduction in investment returns caused by taxes on various forms of investment income. Understanding how tax drag affects investment returns is crucial for maximizing your wealth potential and the value of your business.
As a small business owner in Canada (Ontario), you benefit from paying tax at a 12.2% rate on profits. This allows you to retain more earnings within your corporation for investment purposes.
The big problem with investing inside your corporation is that if you use profits to purchase investments that pay income or make distributions, it gets taxed at an extremely high rate.
Example of Tax Drag
For example, you have 100k of leftover profit inside your corporation at year end (after paying 12.2% tax), and you decide to invest inside your corp. You choose a Balanced mutual fund because you’re not looking to take on a lot of risk and these assets inside your corp. are for retirement. Your mutual fund averages a 5% return based off it’s yield of 2% interest, a 2% dividend yield and 1% capital gain.
If held within your corporation, the following tax rates will diminish your return:
– The interest income will get taxed at 50.2%
– The dividends will get taxed at 39.3%
– The capital gains will get taxed at 25.1%
Essentially, a 5% return turns into a 3% return after tax – a 2% tax drag.
Effects over time?
The compounding effect of tax drag can be substantial over the long term. Even seemingly small tax rates can significantly erode investment returns over time. As taxes reduce the initial investment amount and subsequent returns, the compounding effect is diminished, resulting in lower overall wealth accumulation for the business owner.
What’s the solution? As a business owner, if you want to invest in stocks, bonds, ETFs or mutual funds, you should focus on investments that pay NO distributions/report no distributions. That means, no recurring dividends, interests, or capital gains.
Which types of investments produce no or low dividends and are best for business owners?
– Growth stocks that pay no or low dividends
– Growth ETFs and Mutual funds
– Corporate Class Mutual funds and Corporate Class ETFs
– Private non-liquid investments
Eventually, at some point down the road, you will need to pay tax when you sell your investment and trigger a gain inside your corp. But you’ll have enjoyed years of growth on money that’s been hardly taxed, and you’ll be WAY ahead of everybody else.
If you’re interested in seeing how we can help, please feel free to book an intro meeting.