Paying Yourself as a Business Owner: T4 Salary vs. T5 Dividends – The Ultimate Guide
Deciding how to pay yourself as a business owner—through a T4 salary or T5 dividends—is one of the most important financial decisions you’ll make. Both options have unique benefits and drawbacks, and the right choice depends on your tax situation, retirement goals, and cash flow needs. In this guide, we’ll break down the pros and cons of each method, provide real-life examples, and explain what happens in the event of bankruptcy.
What is a T4 Salary?
A T4 salary is employment income paid to you as a business owner or employee. It’s reported on a T4 slip and is subject to income tax, CPP contributions, and potentially EI premiums. Here’s a detailed look at the benefits and drawbacks of paying yourself a salary.
Pros of Paying Yourself a Salary (T4)
- CPP Contributions & Pension Benefits
When you pay yourself a salary, you and your company contribute to the Canada Pension Plan (CPP). This helps you build up government pension benefits for retirement. While CPP contributions increase your costs, they provide long-term financial security.
Example: If you pay yourself a $60,000 salary, both you and your company will contribute to CPP, helping you qualify for future pension benefits.
- RRSP Contribution Room
Salary counts as earned income, which creates RRSP contribution room. This allows you to save for retirement while reducing your taxable income through RRSP contributions.
Example: A 60,000 salary creates 60,000 salary creates 10,800 in RRSP contribution room (18% of earned income), giving you a tax-advantaged way to save for retirement.
- Predictable Tax Withholding
With a salary, income tax is deducted at source, meaning you won’t face a large tax bill at year-end. This makes tax planning easier and more predictable.
Example: If you earn $5,000 per month, your payroll system will automatically deduct taxes, CPP, and EI, leaving you with a predictable net income.
- Easier Loan & Mortgage Approval
Lenders prefer steady T4 income when evaluating loan applications. A consistent salary makes it easier to qualify for mortgages, business loans, or other financing.
Example: If you apply for a mortgage, banks will look at your T4 income to determine your borrowing capacity. A steady salary makes you a more attractive borrower.
- Reduces Corporate Taxes
Salary is a deductible business expense, which lowers your corporation’s taxable income. This can result in significant corporate tax savings.
Example: If your corporation earns 100,000 and pays you a100,000 and pays you a 60,000 salary, the taxable income drops to $40,000, reducing the corporate tax owed.
Cons of Paying Yourself a Salary (T4)
- Mandatory CPP Contributions
Both you and your company must pay CPP contributions, which can increase your costs. For some business owners, this can feel like an unnecessary expense.
Example: In 2023, the CPP contribution rate is 5.95% for both employer and employee, up to a maximum of $3,754.45 each.
- Less Flexibility
Salaries must be paid regularly (e.g., bi-weekly or monthly), whereas dividends can be paid at any time. This can limit your cash flow flexibility.
Example: If your business has a slow month, you still need to pay yourself a salary, which could strain your finances.
- Higher Personal Tax Rates
Salary is taxed at regular personal tax rates, which can be higher than the tax rates on dividends. This could mean paying more in taxes, depending on your income level.
Example: A $60,000 salary may be taxed at 20-30%, while dividends could be taxed at a lower rate due to the dividend tax credit.
- More Administrative Work
Payroll requires setting up a system, handling source deductions, remitting taxes, and filing T4 slips. This can be time-consuming and may require professional help.
Example: If you’re a solo entrepreneur, setting up payroll just for yourself can feel like a hassle.
What About T5 Dividends?
Dividends are payments made to shareholders from the company’s profits. They’re taxed differently than salary and offer more flexibility, but they come with their own set of pros and cons.
Pros of Paying Yourself Dividends (T5)
- Lower Personal Tax Rates
Dividends are taxed at a lower rate than salary due to the dividend tax credit. This can result in significant tax savings, especially for higher-income earners.
Example: A 60,000 dividend maybe taxed at a lower rate than a 60,000 dividend may be taxed at a lower rate than a 60,000 salary, saving you money.
- No CPP Contributions
Dividends don’t require CPP contributions, saving you and your company money. However, this also means you won’t build up CPP benefits for retirement.
Example: Paying yourself $60,000 in dividends means no CPP contributions, saving you thousands of dollars.
- Flexibility in Payments
Dividends can be paid at any time, giving you more control over your cash flow. You can pay yourself when the business is doing well and hold off during slower periods.
Example: If your business has a strong quarter, you can pay yourself a large dividend. If cash flow is tight, you can skip the payment.
- Less Administrative Work
Dividends don’t require payroll setup or source deductions. You’ll still need to file a T5 slip, but the administrative burden is much lower than with salary.
Example: Instead of managing payroll every month, you can issue a dividend payment when it makes sense for your business.
Cons of Paying Yourself Dividends (T5)
- No RRSP Contribution Room
Dividends don’t count as earned income, so they don’t create RRSP contribution room. If retirement savings are a priority, this could be a disadvantage.
Example: A $60,000 dividend won’t create any RRSP contribution room, limiting your ability to save for retirement.
- No CPP or EI Benefits
Since dividends don’t require CPP contributions, you won’t build up CPP benefits. Additionally, you won’t qualify for Employment Insurance (EI) if your business fails.
Example: If your business goes bankrupt and you’ve only paid yourself dividends, you won’t be eligible for EI benefits.
- Harder to Qualify for Loans
Lenders prefer steady T4 income when evaluating loan applications. If you only pay yourself dividends, it may be harder to qualify for a mortgage or business loan.
Example: If you apply for a mortgage with only dividend income, the bank may view your income as less stable, making it harder to get approved.
T4 Salary vs. T5 Dividends: Side-by-Side Comparison
Here’s a quick comparison table to help you decide between T4 salary and T5 dividends:
|
Factor |
T4 (Salary) |
T5 (Dividends) |
|
Tax Treatment |
Taxed as regular income at personal tax rates |
Taxed at lower dividend tax rates due to dividend tax credit |
|
Corporate Tax Impact |
Salary is a business expense, reducing corporate taxable income |
Paid from after-tax corporate income (corporation pays tax first) |
|
CPP Contributions |
Required (both employer & employee portions) |
Not required (no CPP contributions) |
|
RRSP Contribution Room |
Increases RRSP contribution room |
Does not create RRSP contribution room |
|
Flexibility in Payments |
Must be paid regularly |
Can be paid at any time, offering flexibility |
|
Tax Withholding |
Income tax deducted at source |
No tax deducted at source; individual must plan for taxes |
|
Administrative Burden |
Requires payroll setup, source deductions, and T4 filing |
Minimal paperwork, no payroll setup needed |
|
Best for Mortgage & Loan Applications? |
Yes, lenders prefer steady T4 income |
May be harder to qualify for loans with dividend-only income |
|
Government Benefits (EI, CPP, etc.) |
Qualifies for CPP and other benefits |
Does not contribute to government benefits |
|
Overall Tax Efficiency |
Lower corporate tax but higher personal tax |
Lower personal tax, but corporate tax paid first |
|
Best for: |
Those who want CPP benefits, RRSP contributions, and steady income |
Those who prefer tax efficiency, flexibility, and lower admin work |
Which One Should You Choose?
The choice between salary and dividends depends on your financial goals:
- Choose T4 (Salary) if you want CPP benefits, RRSP contribution room, and steady income. This is ideal for retirement planning and loan applications.
- Choose T5 (Dividends) if you want lower taxes, flexibility in payments, and minimal administrative work. This is ideal for tax efficiency and cash flow control.
- Many business owners use a mix of both to balance tax savings, retirement planning, and cash flow flexibility.
What Happens in Bankruptcy?
If your business faces bankruptcy, how you’ve paid yourself can have significant consequences:
- Salary (T4): Salaries are considered employee wages, which may have priority in bankruptcy proceedings. This means you’re less likely to face claw backs from creditors. Additionally, if you’ve paid into EI, you may qualify for Employment Insurance benefits if your business fails.
- Dividends (T5): Dividends are considered profit distributions, and if they were paid while the company was insolvent, they could be reversed by creditors. Directors may also be held personally liable for wrongful distributions.
Example: If your company goes bankrupt and you’ve paid yourself $50,000 in dividends while the company was insolvent, creditors could demand that money back. On the other hand, if you paid yourself a salary, it’s less likely to be clawed back.
Conclusion
Deciding between a T4 salary and T5 dividends is a key financial decision for business owners. A salary offers stability, retirement benefits, and easier access to loans, but it comes with higher taxes and more administrative work. Dividends offer tax efficiency and flexibility, but they don’t contribute to CPP or RRSPs and can be riskier in bankruptcy.
Many business owners find that a mix of salary and dividends works best, allowing them to balance tax savings, retirement planning, and cash flow needs. If you’re unsure, consult with a tax professional or financial advisor to create a strategy tailored to your business.
