The Tax Trap of Retained Earnings: Why the 'Clever' Strategy Cost Sam $10,200 More

Every year, we see business owners get the same advice from their accountant: retain profits in the company, pay yourself a low salary, and save on tax. It sounds clever. The company tax rate is 28%, your personal rate could be 33% or 39%, so leave the money in the company and pay less tax. Simple, right?

Not quite. What this advice ignores, and what most accountants never think about, is what happens when you actually need the money. Because eventually, you will. And when you do, the 'savings' evaporate. Often, you end up paying more.

Let us walk through a real scenario. The names are fictional, but the numbers are not.

Meet Sam

Sam runs a company that earns $170,000 in profit each year. Sam's accountant suggests two approaches.

Strategy A: Keep it simple. Pay it all out as salary

Sam pays himself a $170,000 salary each year. Personal tax on $170,000 is $47,020 per year under NZ marginal rates. After tax, Sam takes home $122,980 in cash, every single year, consistently.

Strategy B: The 'clever' approach. Retain earnings in the company

Sam pays himself only $80,000 and leaves $90,000 sitting in the company. Personal tax on $80,000 is $17,320. Company tax on the retained $90,000 is $25,200 (at 28%). Total tax in year one: $42,520. That is about $4,500 less than Strategy A. Sam's accountant pats themselves on the back. Job done.

Year two, same thing. Another $4,500 'saved'. Over two years, Sam thinks he is ahead by roughly $9,000.

Then Life Happens

In year three, Sam wants to buy a house. He needs the retained earnings ($180,000 accumulated over two years) plus the current year's profit. He takes the lot as a dividend.

Year three income: $80,000 salary plus $270,000 in dividends (three years of retained earnings at $90,000 per year). Total taxable income: $350,000.

Gross personal tax on $350,000: $116,620. Sam gets imputation credits for the company tax already paid on those dividends ($75,600), but he also has this year's company tax of $25,200 on the retained portion. Net year three tax: $66,220.

Add the two years of combined tax already paid ($42,520 × 2 = $85,040), and Sam's total tax bill over three years under Strategy B comes to $151,260.

The Three-Year Comparison

Strategy A (simple salary): $47,020 × 3 = $141,060 total tax over three years.

Strategy B (retained earnings): $42,520 + $42,520 + $66,220 = $151,260 total tax over three years.

“The 'clever' strategy cost Sam $10,200 more in tax over three years. Not less. More.”

Why Does This Happen?

One word: bunching. New Zealand's personal tax system is progressive: the more you earn in a single year, the higher your marginal rate. By retaining profits for two years and then extracting them all at once, Sam pushed his year-three income from $170,000 to $350,000. That extra income gets taxed at 33% and 39%, which is higher than the rates he would have paid if he had spread the income evenly across all three years.

The company tax at 28% is not a saving. It is a prepayment. When Sam eventually extracts the money, he gets imputation credits for the company tax already paid, but the personal tax on the grossed-up dividend still pushes him into higher brackets. The net effect is that he pays more total tax than if he had just taken a consistent salary each year.

It Gets Worse: The Bank Problem

Tax is not even the biggest issue. Remember, Sam wants to buy a house in year three. Here is what the bank sees:

• ●Strategy A: Sam earned $170,000 in each of the past three years. Consistent, reliable income. Easy to assess. Easy to lend against.
• ●Strategy B: Sam earned $80,000 in years one and two, then $350,000 in year three. The bank sees wildly inconsistent income and does not know which number to believe. Most banks will average the income or use the lower figure, meaning Sam's borrowing capacity is significantly reduced.

Banks lend on personal income, not company profits. If your personal income is artificially low because you are retaining earnings in the company, you are handicapping your borrowing capacity at exactly the moment you need it most.

The Hidden Costs Nobody Mentions

Beyond the tax and lending issues, Strategy B created a cascade of additional costs that the original advice never accounted for:

• ●Two lots of provisional tax. Sam now has provisional tax obligations for both the company AND personally, meaning two sets of instalment dates to manage and two lots of use-of-money interest risk if he gets them wrong
• ●Higher accounting fees. The accountant now has to manage an ICA reconciliation, prepare dividend declarations, handle the company return separately, and advise on extraction timing. A shareholder salary is typically included as part of year-end accounts. A dividend declaration is extra work, extra cost.
• ●Dead money earning 1%. Those retained earnings sat in the company's business savings account earning next to nothing, while Strategy A Sam had that cash in hand and could invest it, pay down debt, or put it to genuinely productive use
• ●Less personal cash flow in years one and two. Sam had roughly $62,680 in hand per year instead of $122,980
• ●If Sam had needed the money before year three (car trouble, medical bills, an opportunity), he would have faced the same extraction problem, with the same tax hit

Meanwhile, Strategy A Sam easily secured a mortgage on the basis of three years of consistent $170,000 income, had one clean set of provisional tax obligations, and invested the difference into something that actually earned a return. Simple, clean, and better off in every measurable way.

When Retaining Earnings Does Make Sense

To be fair, there are legitimate reasons to retain profits in a company:

• ●Growth capital: if the company needs cash to fund expansion, new hires, or inventory, retaining earnings avoids the cost and complexity of extracting money and then reinvesting it
• ●Equipment and asset purchases: if the company is buying plant, vehicles, or property, retaining profits to fund those purchases is commercially sensible
• ●Working capital: seasonal businesses or those with lumpy cash flow may need a buffer in the company
• ●Long-term investment through the company: if you never intend to extract the funds personally, the company rate of 28% is genuinely lower than the top personal rate

The key distinction is purpose. Retaining earnings for a genuine commercial reason is sound business practice. Retaining earnings purely to defer personal tax, with no plan for when or how you will extract them, is a trap.

"But What About a Holdings Company?"

This is usually the next question. And it is a good one, with a nuanced answer that depends entirely on which side of the Tasman you are on.

In Australia, a holdings company structure can make genuine sense. Australia has capital gains tax, so holding appreciating assets (shares, property) inside a company that can offset gains against losses, manage timing, and access the 50% CGT discount for individuals on disposal, there is real tax planning value in getting the structure right.

In New Zealand, we do not have a general capital gains tax. Which means a holdings company can actually work against you. If you hold assets personally and they appreciate in value, those gains are generally non-taxable. But if you bring those same assets into a company (even a holdings company), you may be creating a taxable environment where one did not need to exist. The company still pays tax on any income from those assets, and when you want to extract the value, you are back to the same dividend extraction problem Sam faced.

Holdings companies in NZ can still serve a purpose: asset protection, succession planning, separating trading risk from investment assets. But using one purely for tax efficiency without understanding the NZ context is a classic example of importing Australian thinking into a New Zealand structure. It is one of the most common mistakes we see from business owners who have received advice from someone who does not truly understand both systems.

“That is why you need an advisor who sees it from both sides of the Tasman, not just one playbook applied everywhere.”

The Real Value of Good Advice

None of this is to say that tax planning structures are always wrong or always right. Retained earnings, holdings companies, trusts, look-through companies: each has a place, and each can be the right answer in the right circumstances. The problem is not the structures themselves. The problem is applying them without understanding the full picture: your personal goals, your lending needs, your cash flow, your risk profile, and the specific tax rules of the jurisdiction you are in.

Most accountants focus on minimising this year's tax bill. That is the metric they optimise for, and it is the number their clients see. But minimising tax in isolation, without considering cash flow, lending capacity, future extraction costs, and the life decisions their client is heading towards, is not good advice. It is narrow advice.

The real value of a good tax advisor is not minimising your tax bill. It is optimising your whole financial position: tax, cash flow, borrowing capacity, and long-term wealth. Sometimes that means paying slightly more tax now so that you have a consistent income the bank can lend against, money in your pocket when you need it, and a structure simple enough that your accounting fees stay reasonable.

“This is why you need an advisor who thinks laterally, not just about today's tax bill, but about where you're headed.”

Sometimes the simplest approach (pay yourself, pay the tax, bank the profit) is genuinely the best one.