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Personal cash management: the foundation of wealth
Marilyn runs a successful company. Six years ago she started with a modest loan from her parents, two part-time employees and a dream: to become the largest electronic parts supplier in Western Canada. Today, she's the third-largest supplier in the province and employs more than 20 people. Marilyn enjoys the success of her company, but her personal wealth isn't all she expected it to be after years of hard work and sacrifice.
The characteristic shared by most entrepreneurs is an intense focus on growing the business. This singular focus can cause problems, however, when it excludes other key factors for success. One such factor, often the main element motivating most entrepreneurs, is the creation of personal wealth that is protected from the operating risks of the business.
Developing a personal financial plan at the same time as you work on your business' growth and success should be key for every entrepreneur. And laying the foundation for any system of generating and managing personal wealth involves developing a plan for cash management.
What is cash management? It's the understanding and analysis of your earnings, their taxation, and your expenses.
Your earnings
Most Canadians are employees who have very little control over how much they earn. But incorporated entrepreneurs enjoy a great advantage here: they can choose how much they pay themselves, creating several opportunities to reduce personal and corporate income taxes.
There are two basic ways to realize these tax advantages. First, pay sufficient salaries to yourself and employed family members to reduce the earnings of your business below the threshold rate ($300,000 - $475,000, depending on which province you're in).
Second, when possible, pay yourself and family members enough salary ($106,000 currently) to maximize allowable contributions to RRSPs in 2007 ($19,000).
The form of your earnings
Entrepreneurs also enjoy the advantage of determining what form their earnings will take. Shareholders of a private Canadian corporation have the option to receive corporate earnings in the form of dividends, which are taxed at a lower rate and could provide the corporation with a tax refund.
Every entrepreneur will have an optimum salary/dividend mix for personal and family income. This mix is based on tax considerations for both the business and the household. It may be worth the expense of hiring a professional advisor to ensure you're optimizing this mix.
How much you spend
This sensitive issue is the main reason why cash management is the most neglected area of personal finance. A general rule of thumb is to save 10 per cent of your after-tax income. If you habitually spend more than 90 per cent of your net income, you are risking important life goals such as a comfortable retirement. Depending on your objectives, you might need to save more than 10 per cent of your net income. Getting professional advice in this area could help you project your situation, establish your required level of savings and maximize your financial position.
If you have never looked at your expenses in detail, you could analyze your previous year's spending by preparing a breakdown of all amounts paid out of your bank accounts and charged to your credit cards and lines of credit. Try to group your expenses under logical classifications that fit your particular spending patterns. If this seems like an exercise you simply don't have time for, software is available on the market today that can help speed the process along. Very few people actually perform this exercise, but the results can be very enlightening.
Think short and long term
The cardinal rule about spending is that you must think both short and long term. Ensure you are aware of the consequences of spending today versus saving for tomorrow. Short-term gratification may result in unachieved long-term goals. Most people can live comfortably in retirement on 70 to 80 per cent of their pre-retirement income (adjusted for inflation). Meeting this target requires dedicated long-term planning. Generally, the principal sources of retirement income for entrepreneurs are their investment in their business, government pension plans and RRSPs.
As this may be insufficient, you may have to develop resources through other savings and investment strategies. One of the smartest choices you can make is to contribute to tax-sheltered investment vehicles like RRSPs and RESPs. By doing so, you reduce your taxes, introduce the benefits of tax-deferred growth in your personal investment strategy and/or split your income with other family members.
Other objectives would be to:
- crystallize capital gains exemption and multiply access to the $500,000 capital gains exemption with other family members;
- restructure investments to make interest deductible;
- create an Individual Pension Plan (IPP) if you earn more than $100,000 and are over 53 years old;
- pay retiring allowances to family members who cease working for your business (transfers to an RRSP are permitted up to $2,000 for each year of service before 1996, plus $1,500 for each year of service before 1989 for which they have no vested rights in a pension plan);
- pay a death benefit in recognition of deceased family member's service ($10,000 is exempt);
- declare tax-free capital dividends if your company earned capital gains; and
- make a tax-free repayment of capital.
This article has explored some of the most important issues about personal cash management for entrepreneurs. Remember that a balanced personal financial plan should consider all aspects of personal tax planning, as well as investment strategies and risk management. One point remains paramount in planning your personal wealth: run your personal finances as well as you run your business.
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