Starting Your Own Business? Prepare Your Finances First
Making the leap from employee to entrepreneur needs the right pre-planning.
Whether you’re young and want to set your own path, looking for a fresh start mid-career or saying no to a traditional retirement, launching a business can be an enticing option. You won’t be alone. According to the Global Entrepreneurship Monitor, Canada far outpaces all other G7 nations – including the United States – in new business formation.1
But don’t expect success to come easily. Industry Canada reports that, on average, only 43% of new firms are still standing after ten years. While having a solid business plan is essential, there’s more to becoming your own boss than meets the eye. The first step? Make sure your financial house is in tip-top shape, before you make the jump.
Working for yourself: what’s different?
Self-employment has lots of advantages. You’ll have more flexibility with your time than people who work for somebody else. You don’t have to pay into federal Employment Insurance if you don’t want to. Then there are the potential tax benefits, from having a wide range of deductible expenses to splitting business income with family members.
Still, getting a business up and running has its challenges. As a self-employed person, you’ll be on the hook for both employee and employer Canada Pension Plan premiums. Say goodbye to paid vacation time, group health plans and a company pension. You’ll need sharp recordkeeping. A variable income can make credit more difficult to get. Even losing the social connections of the office might turn out to be a bigger deal than you think.
Don’t quit your job prematurely
You shouldn’t expect your business to generate profit on day one, so you’ll need steady cash flow to support you and your family until it does. That’s why it’s usually wise to stay in your current position and treat your business as a side venture at first, rather than quitting outright and confronting a make-or-break situation.
Use your employment income to cover day-to-day expenses and fund your business’ start-up costs, while building up an emergency fund. Life as an entrepreneur is inherently unpredictable, making a cash reserve essential. Dealing with a stack of bills at the same time your major client is late mailing you a cheque can put you in a bind. Plus, if you’re sick or injured, having a cushion will help take care of expenses until insurance benefits kick in.
Devising an income plan
How much will be coming in each month? How much will be going out? What discretionary spending could you pare back? Answering these questions will let you calculate the amount of money you’ll need from your venture to meet operating costs, as well as fund your own living expenses.
If your business is incorporated, you’ll have more discretion when managing income. You can draw income as salary or dividends. There are advantages to each. Salary is earned income for purposes of calculating RRSP contribution room. Dividends receive preferential tax treatment. Your advisor can map out the pros and cons of each option.
If you’re an older entrepreneur there’s another wrinkle to consider when devising your income strategy: how to handle Canada Pension Plan benefits.
Extending your career beyond the normal retirement age has implications for deciding when to begin receiving CPP. If you can afford to, holding off until after age 65 to collect can boost your monthly payout – as much as 42% if you wait to age 70. Remember, it’s considered taxable income, so plan carefully. Tacking CPP onto your business and other income could force you into a higher marginal tax rate.
Keeping your business and personal expenses separate
You’re used to your employer managing routine tax deductions from your paycheque. But, once you’re working for yourself the chore of managing income tax falls to you alone. The good news is you’ll be able to deduct costs related to your business operations, from office supplies, advertising and your cell phone, to vehicle expenses. Have a home office? You could be eligible to deduct a portion of residential expenses like utilities, property taxes and mortgage interest.
Identifying those tax-saving opportunities will be simpler if you establish separate bank and credit card accounts for your personal and business transactions right out of the gate. The Canada Revenue Agency requires financial records be kept for a minimum of six years to support your filings, so it pays to be organized.
How often must you remit? Once your net tax owing for the current year, and either of the previous two years, exceeds $3,000 (outside of Quebec), you’ll have to pay income tax quarterly. And, don’t forget about additional obligations like CPP premiums.
Ready to take more control of your retirement savings?
Not only should entrepreneurship prompt a review of your retirement plans, quitting your job also means you can no longer add to your company pension, putting more responsibility for your retirement savings in your hands.
The upside if you’re incorporated is you’ll see generally lower tax rates, plus, you can build wealth by reinvesting in your business. The Lifetime Capital Gains Exemption ($848,252 for 2018) can let you hold on to more of your accumulated profits when you eventually sell qualifying small business shares.
At the same time, there’s danger in leaning too heavily on your business’ value to pay for your retirement. Your enterprise could hit hard times, or you might have trouble finding the right buyer when you’re looking to sell. Don’t ignore the diversification and tax-saving benefits of contributing to your RRSP and TFSA. A TFSA can do double-duty as an emergency fund and may be the better choice if your annual income is modest, say under $40,000. The higher your income, and tax bracket, the more valuable tax deductions for contributing to an RRSP become.
What can I do with my company pension?
If you’ve been a part of your employer’s pension plan for years, you expect it to be a cornerstone for retirement. That said, what happens once you shift to self-employment? You could have several choices, such as remaining in the plan, using your pension’s value to purchase an annuity or transferring the funds to a locked-in RSP or locked-in retirement account. Ask your advisor to help you evaluate your options.
Don’t let insurance protection fall through the cracks
Stepping out on your own means you won’t be able to rely on employer group insurance benefits any longer. But the need to protect your financial security doesn’t go away. If you’re seriously ill or injured, for example, the fallout to your business and family could be devastating.
Having proper coverage could mean holding life insurance and an extended health plan, as well as protection against disability, critical illness and liability. Key person insurance might also be part of the mix to sustain your operations should you lose a key employee or business partner through death or disability.
An advantage individual insurance offers over group coverage is the ability to tailor protection to your needs. Depending on your circumstances, you may be able to deduct certain insurance premiums from business income, reducing your tax bill.
Qualifying for a Mortgage When You’re Self-Employed
If you’re a young entrepreneur, buying a home – and qualifying for a mortgage – is likely on your radar. The trouble is lenders often view self-employed people as higher-risk borrowers. Here are three ways to ease the path to approval.
Chat with your lender. Speak with your lender well in advance of applying for a mortgage. Discuss your existing debt, revenues, expenses and where your business is going. Being too aggressive when claiming expenses at tax time can lower your net income and hike your debt-to-income ratio, making it more difficult to qualify. The key is understanding how your income, tax picture and mortgage can work together to give you the maximum benefit.
Be prepared to prove your income. Income validation involves providing documentation like income tax returns, notices of assessment and your business’ financial statements for at least the previous two years, as well as showing your GST account is fully paid.
Keep your credit score healthy. A solid credit score and sound credit history can go a long way in supporting your mortgage application. Regularly check your credit file, available through Canada’s two national credit bureaus, Equifax and TransUnion. Be sure to correct any mistakes promptly.
We’re here to help
There are plenty of moving pieces when you transition from employee to running a business of your own. That’s why pre-planning is so important.
Your BlueShore Financial advisor will help you navigate the challenges and work with you to build a financial plan that’s comprehensive, yet flexible, so you can accomplish your personal and professional goals. Speak with us today.