With the New CCPC Passive Income Rules – Is It Bad to be Good?

I previously gave a simplified description of the effects on professionals at different income levels. That basic modelling ignored some of the complexities of taxation and the effects of inflation.

I did that for the basic illustrative purpose of showing that:

  • the effect grows with increasing income
  • the damage is real, but not devastating
  • it is affected by the type of investments that you hold in your corp

In that basic modelling, a moderate income physician earning $350K/yr net of overhead was able to build an over $3M nest egg over 35 years and their retirement income was only decreased by 3% with the new rules. The sigh of relief was audible. That was an oversimplification, but let’s see if it holds up to closer scrutiny.

What we really care about is how the changes could affect our ability to save for retirement and other financial goals. Unfortunately, lifestyle spending, taxes, and inflation all have effects on that in the real world.

Today, in The Sim Lab, we are going to re-look at our moderate income physician who did everything they were told was the “right thing” to do and see what the impact would be on their retirement plans.

Introducing Dr. Sandra D.

Modified from Grease, 1978, RSO Records.

Dr. D was always a bit of a goodie-two-shoes. She sat in the front of the class, studied hard, obeyed all the rules, and eventually started a medical practice at the age of 30. She lived frugally and graduated with no debt. She has a good set-up, works hard, and makes $350K/yr after overhead. Tell me more, tell more… does she drive a nice car?

Yes, she does. She gets a new car every few years because she feels it will be more reliable. She tries really hard to be good, but her main character flaw is that she cares too much about what other people think is good. She is all “Look at me, I’m Sandra Dee”. She also is paying for a classic “doctor house”, her two kids (and their extra-curricular activities). Her husband became their homemaker to provide stability for the family while she developed her high profile big earning career. Overall, their lifestyle spending is $180K/yr.

Her accountant advised that she take her income as dividends for simplicity, to avoid paying into the Canada Pension Plan, and to trigger the Refundable Dividend Tax On Hand (RDTOH) each year – minimizing any tax drag in her corporate portfolio to maximize its tax deferred growth. She can no longer short-term income split using dividends, and now needs to pay herself $270K in ineligible dividends to get enough to cover her lifestyle.

She sets aside $37K per year to save for retirement. She read somewhere that you should save 10-15% of your income for retirement and her savings rate works out to be 10% of gross or 16% of net income. Following her advisor’s advice, she keeps that all as retained earnings in the corp to maximize tax deferral and invests in a balanced 60:40 portfolio that is expected to return an average of 6%/yr as outlined in the thumbnail. Add in 2%/yr average inflation and that gives a 4%/yr real return.

Over the course of 35 years, they continue to spend and save at the same rate. Sandra drops some expenses as her kids grow up and her house is paid off, but she also has some lifestyle creep with more trips and some nice stuff. She works hard and deserves it.

Grease, 1978, RSO Records.

Her husband likes to re-build classic cars and sing/dance with his buds. He deserves it too.

This kind of lifestyle creep is part of human nature and with doctors being human – it is a classic “stupid doctor trick” if excessive. The Dee’s aren’t too bad though – they are still saving 10-15%/yr towards retirement.

Note: There is no visible orange because they did not surpass the new sliding small business tax deduction threshold.

By age 65, they have built a $2.5M portfolio in “current dollars” and she never crosses the new CCPC passive income threshold into the penalty box. She could draw off $99K/yr at a “safe” 4% withdrawal rate for retirement.

If she waits until after age 65 to retire and can split dividends with her husband, that would translate into $93K/yr after tax. That is not a bad income compared to the average Canadian. However, it would require them to adjust their lifestyle cost downwards. They can spend less on trips, cars, and stuff – or they can eat cat food. On the bright side, they would still qualify for Old Age Security, so could upgrade to Fancy Feast.

Sandra D. Fits the Mould of What Many Would Consider Success

She lives a good lifestyle, both stimulating the economy and projecting her success. She has a successful career. Her main debt was her house, that she pays off over time. She raises her kids with all of the advantages that doctor’s kids are assumed to have, and she can still retire comfortably around age 65.

She is a good girl. She stays out of trouble and doesn’t get punished for having too large of a passive investment income in her CCPC. Ah, but good is a matter of perspective. What if she starts hanging out with a different crowd. Like badass physician finance bloggers, for example.

To run with The Badass financially Independent Retiring early Doctors (T-BIRDs), Sandra needs to change a few things.

Grease, 1978, RSO Records.

I took as much liberty with that acronym as a major pharma trial name. Anyway, she needs a new wardrobe – a less expensive one… but with more leather.

She needs to spend less on her lifestyle, so that she can increase her savings rate. White Coat Investor suggests a physician should be saving 15-20% of their gross income per year rather than the standard 10-15% since we have late career starts to make up for. That should be more like 25-30%/yr, if one is planning to retire early.

Those estimates are in the American context where there is less income tax compared to here. We would need a higher gross savings rate to achieve the same net savings rate after tax. On the other hand, we don’t need to worry about paying for basic health insurance as we age.

How much money you would need to save to be Financially Independent and Retire Early (FIRE) depends largely on how much you plan to spend and how early you want to retire (or RE-focus on more important things than well-paying work – which is how I prefer to look at it).

Many in the general FIRE community achieve this by living on very little money (lean FIRE). As revealed recently by Physician on FIRE, many in the physician FIRE community are going more for fatFIRE – living on >$100K/yr post-RE. To do than in Canada, Sandra D. would need to pay out $130K/yr in dividends from her CCPC and would need a $3.25M portfolio to do that at a 4% withdrawal rate.

What Savings Rate Would Dr. D need to be more badass and fatFIRE?

Using her $350K/yr income, 2% inflation, and the balanced portfolio return already described, if she adjusted her current lifestyle spending (thereby increasing her savings rate) she could achieve fatFIRE in anywhere from 14 years to never.

Of note: Even with being a super badass and saving 52% of her gross income and retiring at age 45 while she still looks good in leather pants – Dr. D never loses her favourable small business tax rate. She crosses the line at the same time that she retires. Since she earns no active income at that point, she doesn’t care about the new rules!

If she continues to work, then she will be progressively penalized over time as shown in the chart below.

 

You see, JT and Wild Bill care about your health. They want you to enjoy life and retire early. Maybe even smoke some legalized weed. But, what if you decide to keep working even after you are FI?

Grease, 1978, RSO Records.

I have. I still enjoy my job, have struck a good balance with my home life, and I want to retire with not just fat-FIRE, but Morbidly Obese FIRE (moFIRE).

Well, that sort of audacity shall not go unpunished with the new passive income rules. Since you would cross into the higher taxed Neutral Zone at the same time as achieving FI, you will pay progressively more tax if you continue working and saving.

I do worry that with our 54% top marginal tax rate kicking in at $220K/yr and these new CCPC passive investment tax rules that our government is really going to disincentivize work for many people.

That is not a problem if there are enough skilled workers to replace those who cut back or RE out of their profession. In fact, it may encourage us to find better work/life balance. However, I am not sure that that is the case in much of medicine. Social engineering can have many unintended consequences and your guess is as good as mine.

How badly would you get spanked for having a high savings rate from living beneath your means and working a long career?

In the chart below, you can see the effects at different savings rates over a 35 year career using the same returns, 2% inflation, and accounting for taxes. The losses to tax due to the new CCPC passive investment income rules kick in at a savings rate of 20% and plateau out to a loss to tax of ~10% at a gross savings rate of 40%.

So, is it bad to be good?

  • For a moderate income doctor, it is not bad to be good. That holds true whether you fit the more popular notion of good or the T-BIRDs badass version of good.
  • If you are super rebellious and want to keep working after achieving FI as a moderately high income professional, then it is “bad”. It is about a “10% decrease in your portfolio size kind of bad”. For perspective, the portfolio sizes in the above bar graph, after a 35yr career of being a good badass, are huge. For example, a 30% gross savings rate for 35 years would give you a portfolio >$6M and provide you with moFIRE if you are over 65 and can income split dividends.
  • We are talking 1st world problems here. The new rules won’t result in impoverished high income professionals. We will still be able to achieve reasonable financial goals.
  • This was a moderately  high income professional. Higher income or double professional families have higher incomes and often higher supporting costs. They will be more significantly affected by the new rules as conceptually illustrated in the basic analysis. We will scrutinize their situations more precisely in future simulations.

Why should we care?

It is important to consider whether you are impacted by the new changes or not.

  • There are simple ways to avoid extra business tax from wandering into the penalty zone, and ways to get yourself out if you do. However, these more complex strategies to decrease corporate tax come at a higher cost in fees and some carry other risks. If you aren’t going to have a problem, then why take on more costs or risks?
  • Some strategies may even lower risk by diversifying against tax risk and cost little or nothing.
  • If you are going to be affected, then you should educate yourself about the options, so that you can use them.
  • If you are not going to be affected, then you should be aware because some of the potential “solutions-to-a-problem-that-you-don’t-have” come with motivating commissions.

Learning about the potential products and strategies to navigate around the new CCPC passive income tax rules is where we will head to next in the Financial Anatomy and Financial Planning Physiology sections of the site over the next few weeks.

14 comments

  1. Hello LD!

    Yes, we are looking forward to getting spanked regardless. My accountant told me that I could 1) get IPP’s 2) buy more RE 3) look into life insurance.

    I’m going to buy more RE but outside that CCPC. The permutations are hurting my head. I will also be looking into life insurance options later as well. But for now- I’m doing nadda.

    ALSO- you are doing a huge service for physicians. It has costs us about 2K just to sit and review options with our accountant. And we are still no closer to any resolution.

    1. Hi Dr. MB.
      I think that advisors and those who sell products like IPPs, insurance, and those who do the actuary work for pension plans etc (like Mourneau Shepell, for example) will benefit from the proposed legislation for sure. Careful planning will be key for those who either earn or save large sums and want to keep working without getting penalized. I am discovering other less costly options that may work for some. Not all are well promoted by the financial industry. I just finished the first article introducing some of the tools/strategies and will use some cases to explore their application further. I think that you are wise to not take any major actions yet- this onion has many layers that need to be peeled off (may make us cry). What actions are needed (if any) will depend on a number of factors.

      That was a pricey accountant visit – I think that my accountant probably spoils me, but I am also saving money figuring things out via researching for the blog. It costs nothing for me to share what I learn (other than time and I am enjoying it – especially the photoshopping). I am also in the phase of my career where I am supposed to be “returning” something to the profession that has given me so much and this seems an important need to be filled.
      -LD

  2. After this tax season is over, I will be sitting down with my accountant to see what his recommendations are for my situation, but I suspect that there will be nothing earth-shattering. But I could be wrong.

    Look forward to hearing what you have discovered in your research!

  3. Good discussion, reminds me of the 4 physician series. !

    Here is my 2 cents. I think there are 2 issues, accumulation and withdrawal with the new tax treatment.
    In the accumulation phase, if the the corporate fund is in taxable account and invested in equity, then a 1.5-2 % dividend/capital gain is reasonable. So at 5M, you are looking at 75K-100K passive income which still leaves 150-225K space. It’s even less a problem if one uses an advisor. Even at 10M, you have 50-100K passive income which gives similar space. So one may not need complex solutions even at high saving levels. It’s a problem at really high saving levels but you run into small business max after 10M anyways.

    I see more planning needed for the withdrawal phase. You can income split after 65, but what if one spouse retires early? I think this is where the advisors/accountant earn their fees.

    Looking forward to your future posts on solutions!

    1. I agree with your thoughts. The type of investment mix, account mix outside the CCPC, and how it generates income will be key and can likely eliminate the problem for many. “Average” earners and savers like in this example shouldn’t even have a problem. Those wanting a higher fixed income type component in their assest mix for the dampening of volatility could still have some planning challenges. Taking salary and using RRSPs will likely solve the problem for most – easy and no special costs. Those mid to late career with big incomes or high savings rates may need some fancier moves to reshuffle. I think it is all doable, but will require more thought and planning than many are used to. The drawdown phase has always been interesting for those who want to retire before 65 and now even more so. It is not talked about much and I am always surprised at how some people are setting themselves up, but planning in advance will make a difference there too. Looking forward to sinking my teeth into that one. Thanks for your thoughtful addition to the conversation as always BC Doc!

  4. Great post! I’m realizing the advantages of only one high income spouse. Many families I know have two high earners and spend double but after tax are not much farther ahead with their ability to save.

    Also these numbers don’t include govt benefits. If two spouses were able to receive oas, cpp, and maybe a pension, then dividends, fat fire happens quickly with a higher savings rate. Then it becomes more about how to plan the withdrawals especially if early retirement is chosen.

    Really fun post, thanks for the efforts.

    1. Hi Phil! My wife (who works for me >20h/week, of course) and I have noted the same thing. Our lives are much less hectic, and my “admin support” is now the best it has ever been by a long shot. Double professional families have some advantages that are increasingly being picked on (income), but also can have way more costs and complexity in their lives from what we have seen.

      CPP and OAS can for sure be part of achieving fatFIRE early with sequencing the drawdown properly as you suggest. If going for moFIRE, then OAS clawbacks could be an issue from drawing so much income – especially with dividend gross ups. Planning using return of capital arrangements, TFSAs, and capital dividends from a CCPC may help that. Lot’s of fun stuff for us to get into as the blog evolves. Thanks for reading and commenting!
      -LD

      1. You’re welcome, it seems tax planning between fat fire and mofire is huge. Even more difficult is to plan for fat fire with the option of mo fire and not standing in its way tax wise. I think the gross up becomes key. Hopefully a period of oas can still be had:)

  5. Hi LD,

    I am really looking forward to your take on the decumulation options. I have been working on ours and the numbers are enlightening.

    I am beginning to think that our sweet spot will be to keep the RRSP/RRIF around the 1 million mark. And I may plan on keeping just fixed income ladders in these to keep it low on purpose. If folks ran a simple excel spreadsheet on their current numbers, they may not like what they see.

    I agree that the decumulation phase is the fun/interesting part of the exercise versus the accumulating.

    1. The draw down phase is going to be fun to explore. It is largely under-discussed when dealing with large portfolios, but as you allude to there are definite issues that can arise if you don’t structure it with an exit plan. RRSPs are great if used properly as one piece of the plan, but could be a tax trap if not.

  6. Thanks for another good post.

    As a dual physician mid-career family, we are into zone of losing the small business tax rate because of the passive income on our retained earnings.

    From what little I know about IPPs, I don’t think they would work for us because our previous compensation from the corp has been mostly dividends. Without much previous T4 salary income from the corporation, I don’t think that we would qualify for enough of an IPP contribution to make the fees worthwhile.

    I am wary of permanent insurance. Fees and commissions are high, and once you have purchased the policy, there is very little flexibility if your circumstances change.

    I told my wife that I am toying with the idea that we should split (she was initially taken aback, until I clarified that it wasn’t the marriage) into two CCPCs. But I’m not sure if I want to take on the added complexity in record keeping, and the added ongoing legal and accounting fees.

    I’m starting to come round to the idea that the solution for me is to cut back and work less.

    1. A solution to progressive taxation that is elegant in its simplicity and far reaching in its implications if more docs start thinking this way.

      I think that our main goal is fulfillment. As professionals, our finances, careers, and fulfillment are inextricably entwined. It is great that you have had taken care of your financial health, so that you can have your career and finances support your fulfillment as the priority in your decision making – rather than have finances dictate them (as happens to people who do not).

  7. I like the idea of morbid obese fire. To go thorough medicine, work hard, save a large chunk of income and retire early to live the frugal life style is something I am trying to avoid.

    What is morbid obese fire? To me, it’s 200k for each spouse. It is below the max bracket and makes me feel like I am not being taxed to death (perceptually as practically it’s a 4% difference). This yields 270k net after tax (assume salary, more if paying out dividends). Which is a pretty sum for a good lifestyle.

    Assume 4% withdrawal, it takes 10m to retire. Gulp! However, one advantage of medicine is the flexibility to do part time. I see a lot of benefit with working part time. You still have something to do, meet some colleagues, pass on knowledge and write off expenses ;).

    I think with proper planning, an early part time retirement in 50s is achievable. It’s also better to do traveling earlier. Gets Harder to adjust to jet lag and longer flights. with travellng and higher priced bucket list out of the way, you will need less at 65 and qualify for OAS!

Leave a Reply

Your email address will not be published. Required fields are marked *