Pay Less Tax Using the CDA
The only sure way to gain in investing is through tax planning. Markets are uncertain and provided that tax policies remain unchanged, planning when you pay taxes will reduce how much tax you pay, over time.
The key to tax planning is knowing the tools.
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Capital Dividend Account (CDA)
A capital dividend account (CDA) is a special corporate tax account that gives shareholders designated capital dividends, tax-free. A capital dividend is a type of payment a firm makes to its shareholders, which is seen as principal rather than earned income. The payment is taken from paid-in capital, and not from the company’s retained earnings as is the case with regular dividends. When capital dividends are paid out to shareholders, these are not taxable because the dividends are viewed as a return of the capital that investors pay in.
A Capital Dividend Account (CDA) can be built by paying into a permanent life insurance policy with corporate money. It can then be accessed through the cash values or death benefit of the policy. This process converts what would be seen as corporate earnings to invested capital, removing the requirement to pay tax on it as a dividend when withdrawn from the corporation.
Build a CDA Plan with Life Insurance
Permanent Life Insurance
Permanent life insurance is a tool that can generate wealth through a cash surrender value. This is like having a savings/investment account embedded within your insurance that can be withdrawn or used as collateral for a loan. This cash value gets special treatment from the Canada Revenue Agency (CRA).
Under section 148(3) of the federal Canadian Income Tax Act, assets that accumulate within a tax-exempt life insurance contract are free of annual accrual taxation. Also, when you pass away, any proceeds of the policy are distributed to your beneficiaries on a tax-free basis outside the scope of your estate, bypassing its associated probate costs.
This is like an RRSP (Registered Retirement Savings Plan) in that growth within the account only gets taxed at disposal and not every year. Unlike an RRSP, only the growth gets taxed when you redeem it, instead of the entirety of the redemption as regular income. With permanent life insurance, you can take advantage of the compounding effect by deferring tax and if you should pass away, the death benefit would be paid out entirely tax-free.
Before diving into corporate tax planning using life insurance, let’s cover some of the basics. Tax-exempt life insurance refers to the cash surrender value of (a) whole life insurance and (b) universal life insurance.
Participating Whole Life (PAR) Insurance
With participating whole life insurance, your insurance company invests all deposits beyond the pure cost of insurance within a large pool composed of similar deposits, from other policyholders. This means that when paying your premium, a portion goes to the cost of your insurance and another portion is allocated to a savings pool. This pool, called the PAR fund, is made up of separate segments to form a conservatively managed portfolio that drives returns. Based largely on the performance of this pool, your insurer returns a portion of your deposits in the form of dividends. In essence, you are participating in the profits of your insurer.
Universal Life (UL) Insurance
Universal life insurance differs from participating whole life insurance, in that many components of the cash surrender value can be controlled by the policyholder and/or their advisor.
With this policy, there is a minimum and maximum annual premiums based on the amount of insurance coverage. Policyholders must make the minimum annual deposit but can also put in as much as the maximum premium if they choose. The maximum can be several times more than the minimum premium and is dependent on your age, gender, health, and the face amount of insurance coverage.
What you deposit above the minimum premium is invested in a variety of investment vehicles and grows tax-deferred.
Building a CDA with Life Insurance
As your corporation grows, it will accumulate retained earnings which are taxable dividends when withdrawn. If your corporation invests in exempt life insurance, a cash surrender value would grow alongside retained earnings, which could later be layered with taxable dividends from your retained earnings in retirement.
In this situation, the corporation would be the policy owner while the corporation owner would be the insured. In retirement, the corporation would borrow against the cash surrender value, contributing the proceeds of the loan to the CDA, where the corporation owner could redeem retained earnings and capital dividends at a 50/50 split over many years. A $100,000 annual income could very well show as a $50,000 taxable income. This is not even accounting for the corporate dividends one can receive tax-free from an eligible Canadian Controlled Private Corporation which can vary by province from $18,694 to $53,810 annually. In essence, the retired corporation owner would have a lower marginal tax rate every year by layering their dividend with capital dividends.
At the passing of the insured, the corporation being the beneficiary of the life insurance policy would receive the death benefit which would-be tax-free, net of the declining adjusted cost base (ACB) of the policy. The death benefit would first pay off the cash surrender value loan, with the remaining amount further contributing to the CDA. This would be timely because the heirs of the corporation would not only be inheriting a corporation (a thriving one because it has retained earning) but with it, a large capital gain. The enlarged CDA could potentially provide the liquidity necessary to avoid them having to dispose of useful assets to pay taxes on the capital gain.
Build a Plan Around the CDA
This strategy may appear sophisticated, but it is really the application of a simple concept. Diversity in asset management is not just about stocks vs. bonds or domestic investments vs. foreign ones. The concept of diversity applied correctly is much broader and should also apply to the tax status of your assets amongst many other categories. Adding diversity of taxation in retirement will give you better control over when to get taxed which (with planning) can directly affect the net amount you get taxed over that period.