Into the Neutral Zone Part 2 – Does The New Passive Income Threshold Actually Matter To Your Savings?

In Star Trek, the Neutral Zone is not a place you want to end up in. This wide border between the conflicting Romulan Star Empire and the Federation of Planets is dangerous.

In Part One of Into The Neutral Zone, we described the gross effects of the new passive income rules on professional corporations. If you cross into the “Neutral Zone” above the Small Business Deduction (SBD) threshold, then you will pay more tax up front. The effectiveness of a corporation for growing your nest egg will be attenuated, but not destroyed. The CCPC Enterprise is still a useful tax deferral vehicle.

Those who are retired and make no active income will avoid problems.

The occasional day-trip into The Neutral Zone will reduce your retirement savings, but it is not devastating, since the SBD threshold resets annually.

However, what could happen to doctors over the long spans of their careers?

Let’s look at three cases to see how they could be affected using proposed 2019 Ontario/Federal Tax Rates.

Case 1: Moderate Income Professional Household

Here is what would happen with a doc starting at age 30 who makes $350K/yr active income and after dispensing money to pay for their personal taxes and lifestyle has $75K/yr to left to pay their corp taxes and invest for retirement. Their initial corp tax is about $44K, so that means they invest $31K/yr until the threshold encroaches on that.

Ignoring the taxes on their investment income, if they have 6%/yr passive investment income, then their passive income would cross the threshold after 21 years at which point they start paying progressively higher corp taxes – leaving less to invest each year.

After 35 years, that would give them a portfolio of $3.2M to retire on instead of $3.7M under the old rules. That would translate to ~15% reduction in retirement income at age 65.

How you make investment income matters. If they have a mixed portfolio of income (3%/yr) and unrealized capital gains (3%/yr), then only half of their total 6% passive income counts each year. As you can see by the very thin orange sliver in the graph above, that means this doc would largely avoid The Neutral Zone until near retirement. They would have $3.6M saved which should provide about $135K/yr pre-tax in retirement. If they had a higher savings rate, then they would grow a larger nest egg, but would also wander into The Neutral Zone earlier. They would only have a 3% reduction in retirement income or they could scale back their active income at that point and work less for that 3% reduction.

Case 2: Higher Income Professional

Let’s look at what happens to a higher earning specialist who has $500K of active income/yr. They are a bit more spendy, but still have $125K/yr to leave in their CCPC to pay the corp taxes and invest. Their initial corporate tax would be $63K/yr leaving them $62K/yr to invest.

Ignoring the drag of tax on passive income, they would pass the sliding SBD threshold much earlier with a 6%/yr return. This happens at 10 years. By year 23, all of their active income would be taxed at the higher general corporate tax rate. That would be $133K/yr in tax which means that they would actually be using $8K/yr from their passive income to help pay the tax on their active income. Fortunately, they have built a large enough portfolio at that point that it continues to grow on its own anyway.

 

If they started saving this way at age 30, they would have $5M when retiring at age 65 compared to $7.5M under the old rules. That would translate into a 30% reduction in retirement income.

If they use a balanced portfolio that grows at 6% with only half of that realized as passive income each year, then the effect is attenuated, but not eliminated. They would have a 22% reduction in retirement income.

Case 3: Very High Income Professional or Double Professional Household

The situation would be more pronounced for a higher income double doctor family. They will cross the threshold much earlier with effects on their asset growth similar to those of the pager on date night.

These folks have a high household CCPC active income of $700K/yr. The costs of a double doctor family are higher to support their careers. For instance, this couple has a live-in nanny, and unlike PM Fancy Socks, they only have one and they have to pay for it themselves. That said, they have a snazzy lifestyle.

They start out paying the general corp tax rate on $200K of their active income from day one. After their living expenses and personal taxes, they still have $200K/yr left in their CCPC each year, of which $116K pays the corp taxes and they invest $84K.

Using the same portfolio growth assumptions as our previous examples, with the new sliding SBD threshold, the proportion that they pay the higher tax rate on will start to grow about 8 years in. This means that each year, they will pay progressively more of their income at the higher general corporate rate and by year 18, they will be taxed completely as a large corporation.

No matter how you slice it, this couple is a money making powerhouse. If they started earning and saving this way at age 30, then they would have $7M when they retire at age 65. Under the old rules, they would have had $10M. So, they have a 30% reduction in retirement income due to the rule change.

If they use a balanced portfolio and realize only half of their 6%/yr passive income, then they would have a 24% reduction in retirement income due to the rule change.

So, do the new rules matter to your savings?

Well, they definitely could have a negative impact as shown above.

  • They reduce the effectiveness of tax deferral using a CCPC, but do not eliminate it. It is still much better than paying personal tax rates up front.
  • The threshold is reset every year, so a spurious wandering into The Neutral Zone will result in some damage to your ship, but not destroy it.
  • If you travel into The Neutral Zone on a more permanent basis, then the Romulans will find you and they will open fire. Your retirement income will sustain damage if that happens.

In our examples, that damage was a 3-30% reduction in retirement income. Even with that, all of these professionals were able to save enough to provide for a $135K/yr to $250K/yr pre-tax retirement income over 35 years. As always, key to that success is starting early and being consistent over a long time frame. What is new is that how you structure your portfolio for tax planning will make a bigger difference.

A note on the assumptions. In our examples, we do assume that you get 6%/yr returns which should be achievable depending on how you invest, based on historical market returns. However, the spending power of that retirement income could be dramatically less due to inflation. The new thresholds are not indexed to inflation in the current proposal (bad), but hopefully that will change eventually. I also ignored the drag of paying taxes on passive income in a CCPC. The effects of those taxes can be complex with the Klingon RDTOH mechanisms, but they could reduce your CCPC portfolio growth. That would delay your crossing into The Neutral Zone, but it would be because of poorer returns – so still not a good thing. The eRDTOH and the active income at the general corporate tax rate also generate the ability to pay out eligible dividends at more favourable tax rates, lowering the personal tax bill. That increased personal cash flow rate could be re-invested – mitigating some of the detrimental effects. I tried to keep these analyses simplistic for illustration, but will do more detailed posts later.

Overall, a trip to The Neutral Zone is undesirable, but it is more like…

What about evasive maneuvers?

There are ways to maneuver to avoid the new passive income rules.

  • One is to retire and no longer earn active income, but for those of us who don’t want to or cannot, there are still other ways.
  • The way that you structure investment income in your portfolio matters. For a moderate income professional who is a moderate saver, you may avoid The Neutral Zone entirely with a balanced portfolio by deferring realizing capital gains. A higher income or higher savings rate professional can attenuate the effects with a balanced portfolio in their CCPC, but would still find themselves in the Neutral Zone… unless they take more measures to navigate around it. I think that it can be done with planning. Stay tuned.
  • If you do find yourself in The Neutral Zone, either as a “one off” navigational error or more consistently, then you can also learn how to dance with the sliding thresholds to minimize the impact.

It does mean that you will need to pay attention and move around like when the Enterprise takes a hit.

We will explore how to navigate and dance in upcoming posts.

Don’t worry. While passive income in 2018 will affect active income business tax in 2019, we still have time to learn to dance and re-position ourselves if needed.

 

Update Note: I want to thank Nick, Dr. Moneyblog, and BC Doc for their great comments below. My original post just had 6%/yr income for my examples. I was trying to keep it simple for illustration (and shorten my marathon length detailed posts), but I think mentioning the effects of deferred capital gains in a balanced portfolio in this post rather than a later one makes it better. Thanks!

 

14 comments

  1. Excellent post.

    2 comments:

    #1. I think in some ways the rules *have* started since the passive income rules are based on the previous year’s passive income. So – although the rules don’t start until the 2019 corporate tax year, the passive income generated in 2018 will be used. (At least according to MD Management… https://www.youtube.com/watch?v=GhlJDWdLJ5s&t=592s). I haven’t seen this mentioned apart from MD.

    #2. Your examples above assume that passive income annually is going to be about 6% of a portfolio. Perhaps I’m quibbling, but that seems a bit high. Certainly you won’t get that from GICs or bonds… If you are using equities then only 50% of your capital gains are taxable… (and you can control when you harvest those gains.)

    1. Thanks Nick.
      #1 Excellent point. I have updated the post to make it more clear. Re-positioning yourself on the passive income side in 2018 will affect 2019. If it is a one-time hit to avoid a long-term problem, then it is likely worth it. However, you can also re-position on the active income side in 2019 to lower active income if needed (increased salary or perhaps using insurance or an IPP in the right circumstances).
      #2 The historical average return of a balanced portfolio has been ~6% over long periods as described in this link. History doesn’t guarantee the future – we have seen average returns >8% for the past 25 years – so we may be in for a downturn at some point. The equity part will generally return more (with more volatility) and the fixed income piece return less (with less volatility) to give the average. If you add in inflation and tax drag, then real returns could be 2-3%/yr less. We can’t do anything about market returns or inflation, but we can position ourselves with the best asset mix and disperse that amongst accounts in the most tax efficient way possible which is what I am shooting for. You hit the nail on the head with your comment about capital gains. By focusing capital gains based investments in the corp and your fixed income elsewhere (or using excluded products) you can lower the tax triggering passive income in your CCPC dramatically. Maybe to nothing. That thinking will be a change for some people who have held all their investments in their CCPC (including income producing real estate, bonds, GICs, high dividend payers etc). My main point in this post was to set the scene that not planning will cost you. With planning, we can avoid “The Neutral Zone” completely for the majority of people.

  2. Hi Dr. LD,

    Interestingly I sat with my accountant and he is sure that there will not be much of an impact on us overall. I think he has voodoo skills. He is with one of the largest accounting firms which works mainly with professionals so I have confidence in him.

    I applaud you for tackling these details. I really look forward to your next segment. He gave me various strategies of IPP, real estate and life insurance. I have to review these options in more detail.

    Many docs will have to use various options since they will be unable to income sprinkle. That part will be what has the largest impact for us since we have two kids in university.

    1. Hi Dr. MB,
      I agree with your accountant. If you don’t plan, then it can affect you like shown in the post. If you plan using a variety of options then you can navigate around it. If very high income, then it may be difficult to completely navigate around it, but there are still ways to mitigate the effects. We are going to look at options to navigate it coming up. It will be a shift for people who are used to simply keeping all investments in the corp and paying dividends for personal income.
      -LD

  3. Hi LD:

    Always enjoy your articles that combines humor with finance.

    Since capital gains can be deferred until a sale, I think a realistic passive income range is around 2-3% for a balanced portfolio. So only the highest income physicians would breach the neutral zone in their lifetime.

    I wonder it would make sense to withdrawal fund at highest personal rate to contribute to TFSA for those with highest income. My guess is no because these physicians would likely need a higher income that disqualifies them for OAS. (My assumption is that TFSA is only beneficial if it lets you stay below that limit)

    1. Hi BC Doc,

      I agree with you regarding the effects overall with a balanced portfolio (2-3%/yr). The fly in the ointment is that the thresholds, as proposed, are not indexed to inflation and will effectively tighten 1-2%/yr in “current dollars” over time unless that is changed. I’d rather proactively position just in case. Some with income producing assets held in their corp like lucrative real estate income or high yield income (if we see that again down the road) could be caught up. It didn’t matter before, but now it could. A high earner or a double professional family could get dinged with this quite easily. The other group in general that I see could be affected are high savers – particularly over a longer career period (since they build large passive income pools). It is not devastating for anyone I think and for everyone, I think that planning will enable navigation around The Neutral Zone for the most part. My main message is that people need to pay attention and plan.

      Good question about the TFSA. I have been thinking about that one. We have always used them because I like the concept of tax diversification and being able to stuff my wife’s TFSA as an income splitting maneuver gives me pleasure under the new tax rules, but I haven’t considered the opportunity cost in detail.

    2. Hello BC Doc,

      The TFSA is one of those wonderful vehicles that one believes is not as useful unless you start to deep dive into it. The money you put in is with after tax dollars but the investments grow tax free and can be withdrawn tax free and does NOT affect your OAS. Thus would not trigger clawbacks. It also does not have the forced withdrawals that the RRIF will incur.

      Small investments allowed to grow long term in a vehicle such as this can become mammoth.

      Re Real estate- this is one asset class that with depreciation, expenses, etc and your accountant’s skills will not trigger much. This is the easiest income to minimize or vanish it. It isn’t call phantom income for nothing.

      Having an excellent accountant has been invaluable to us.

  4. Hi Dr. MB:

    I agree that TFSA is great if you are close to the OAS threshold and real estate has its role. Another option is to own your practice so it’s actve income when you sell.

    Good point about planning, LD. I am the high saver who got caught by the new changes. I figure I could save for less than another decade with various maneuvers. I can then cut down or retire completly. This government is trying to make physicians life/work more balanced and I thought it didn’t care. Liberals for 2019!

    1. Ha! I love it. The government is such a caring parent and knows best about everything – even physician work/life balance. Seriously though, it may actually be a good thing for people to critically examine how much sacrifice is worth what return. I did and scaled back about 20% this year – my family and I are happier for it. I am also fortunate in that there is demand for work in my field (ICU), so there are people itching to pick up the slack. I worry about fields where that is not the case because people do modify their behaviour based on incentives and disincentives.

  5. not sure which post of yours is the best for this question: do you put any fixed income investments in your corporation accounts?
    my advisor recommended to still have some FI investments along with mostly equities

    1. Hi Stan,
      That is an excellent question! I am actually just working on that exact concept as a few posts. The quick answer to your question is that if you have everything in your CCPC and that is enough for you over your career without getting into The Neutral Zone, then you would likely have FI there as part of your balanced equity/fixed income portfolio. If you will run into The Neutral Zone or want to use salary, RRSPs, and other accounts for tax diversification against political risk, then you would want to match your investment types to the most tax appropriate accounts. For example, the CCPC is excellent for equity and an RRSP is excellent for fixed income. This will be a change in thinking for many since the CCPC was a great-one-size-fits-all solution for many years, but now is not. There is more to it than that, everyone’s situation is different, and I am not a professional advisor blah blah blah (my disclaimer).
      -LD

  6. It’ll be interesting to see what “goodies” the government has in store for us in the next few years. I worry that this is just the tip of the iceberg, and that there is more to come. I think that this may be a new norm for us and our accountants, where we’ll be “dancing and repositioning” ourselves from year to year.

    Is there a cloaking device that we can also use, like the Romulans? 🙂

    1. I have the same concerns, but hopefully the rough ride of this round will hold them off for a while. The interpretation and audit factor from CRA is what worries me the most in the immediate future. Love the cloaking device analogy – would be a great post title!

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