Living with an irregular income due to self-employment can play havoc with finances, but there are suggestions that financial advisors can pass on to their clients to help smooth out the bumps in the road.
About 15% of Canada’s working population of 18 million are self-employed, according to Statistics Canada, both entrepreneurs and professionals, and there are different planning and tax strategies, often depending on income:
– Cash flow: Self-employed clients need to set aside two buckets of money for day-to-day living expenses, says Marylou Heenan, a financial advisor and cash-flow specialist with Assante Capital Management Ltd. in Toronto. The first bucket will look after regular payments, such as for a mortgage. The second will be for more discretionary items or costs that can vary week to week.
– Tax-free savings accounts (TFSAs): Put as much as you can into a TFSA, suggests Hank Bulmash, chartered professional accountant and CEO of Bulmash Accounting Professional Corp. in Toronto. Although the initial tax deferral through an RRSP is beneficial while working, a TFSA allows clients to forgo any taxes whenever funds are withdrawn.
– Incorporate: Many entrepreneurs and self-employed professionals start out small, then build up healthy earnings annually. This group of clients should contemplate incorporating if they haven’t already, says Dana Mitchell, a certified financial planner with the Basis Wealth team in Toronto, which operates under the Freedom 55 Financial umbrella. Most of the planning and tax opportunities that can benefit self-employed individuals are found in the incorporated world, making the additional costs of incorporating worthwhile.
– Savings: Incorporated business owners can save like everyone else through their RRSPs. But instead of taking money from their business, these entrepreneurs have the option of saving within their corporation – ideally, a holding company – to get the advantages inherent in this tax-sheltered vehicle, says Mitchell. Business owners can build a bigger savings basket and not be required to make minimum withdrawals at 71.
– Dividends: If your client’s business is incorporated, funds can be withdrawn from the business through dividends, which receive preferential tax treatment. Generally, dividends also can be spread throughout the client’s family, particularly a spouse and adult children. For example, Bulmash says, dividends can be paid out to children going to university to pay for tuition: “The [business] owner doesn’t have to take out money, pay taxes of 40% or so on that and then spend the remaining money on tuition for the children. The owner can pay dividends out to his or her children and, if the children’s dividends are under $40,000, they will pay virtually no taxes on that.”
– Tax benefits: Taxes generally are lower for corporations, both annually and when clients sell their company, says Bulmash. For example, if a client decides to sell his or her incorporated business, that company may be eligible for the small-business exclusion on capital gains for the first $800,000 of capital gains.
– Diversify: For clients who are not incorporated and whose main source of savings is their RRSP, Mitchell recommends including segregated funds, which offer a measure of creditor protection and a guarantee of principal. “The business owner often has most of his or her money in the business, and this gives an element of protection, which is nice when many people put most of their risk in their business.”
– Spousal RRSPs: This strategy is an old one, but a good one for the self-employed, says Bulmash. When one spouse earns considerably more than the other, the higher-income spouse contributes to a spousal RRSP and receives the tax break.
– Life insurance: Clients should start looking at life insurance beyond receiving a tax-free benefit upon death, says Mitchell: “I don’t think insurance is looked at enough as not only a decent investment strategy, depending on the product, but also for overall diversification of your asset mix.”
– Goals: Because of potential setbacks in earnings, Heenan says, the self-employed need to set goals for themselves: “You will have goals for your business; but also set some financial goals for [yourself]. At the end of the day, we have to make choices on how to spend our money. Life goes by so fast, and we’re rushing everywhere, and we’re not aware of our spending.”
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