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.
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.
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.
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.
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?
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.