It is clear to Canadians that our government leaders like to dance. The recent trip governmental trip to India also put this love of dance on display for the whole world to see. Some found it embarrassing whilst others found it entertaining. Personally, I am looking forward to seeing the Right Honourable Mr. Dress-Up on a German tour…
The entertainment value of that would almost make me smile as I do my “fair share”.
The New Passive and Active Income Dance
The new rules will come into effect in 2019. So, we do have some time to learn how to dance. It is kind of like a highschool dance was for me. I didn’t really want to dance, but I wanted to get close to girls even more, so I did it anyway. We may not have much choice other than to step out of our comfort zone and dance – if we are one of the high income professionals potentially affected by the new CCPC passive income tax rule changes.
I did a recent simplified illustration of the potential impact on professionals at different income levels. That was a basic model that ignored some of the nuances of corporate tax, inflation, and non-CCPC investment accounts. The purpose was to show that some will be affected while others won’t and that basic investment income mix matters.
A more detailed analysis accounting for these factors with Dr. Sandra D, a 350K/yr income physician, found that she would be unaffected if she either kept her saving rate low and retired at a traditional age 65 or if she retired as soon as achieving fatFIRE (a portfolio large enough to fund a $100K/yr retirement lifestyle). That should take many potential dancers off the dance floor and make room for the rest to bust a move.
If she were to keep working after achieving fatFIRE, then she would face escalating taxes up to around 10% of her passive income growth, depending on her savings rate. The better at working/saving she is, the worse the tax bite.
More such analyses are in the pipeline for The Sim Lab, but [spoiler alert] the impact is about a 10-15% reduction in portfolio size over a 35 year career span for most docs in the 500K+ income range – if you use only dividends for pay and the CCPC as a monostrategy for retirement saving (as many people have up until this point).
The proposed sliding Small Business Deduction Tax Threshold is like a game of limbo with active business and passive investment income. We are going to have learn the new dance sweeping the nation at high income professional weddings and parties everywhere.
How loooowwww can you gooooo?
Like all annoyingly catchy dances, the moves are relatively simple.
Dance Move 1: Pay Some Salary
Paying salary instead of dividends is one way to reduce your active business income to stay beneath the SBD threshold. There are pros and cons to taking a salary, including:
- Potential loss of tax deferral in the CPCC if you take more individual income than you need
- Contributing to the Canadian Pension Plan (both the employee and employer contributions!)
- Creating RRSP room and/or opening the possibility for an Independent Pension Plan (IPP)
- Paying enough dividends to trigger release of RDTOH to decrease tax drag on your CCPC portfolio returns
Whether these factors are pros or cons will depend on your overall financial situation, investment plan, and how tax integration works out for your province and tax bracket.
Dance Move 2: Restructure Your Portfolio To Minimize Annual Passive Income in the CCPC
Try to put investments that count as passive investment income in non-corporate accounts (RRSPs, TFSAs, taxable/cash accounts) while keeping those that generate no or minimal passive income in the CCPC. You should do this in a way that still keeps your overall goal asset mix. Don’t let the tax tail wag the investment dog.
For example, a simple portfolio restructure aiming for a $1M Corporate Portfolio with a 60:40 stocks:bonds mix could look like this:
It seems simple conceptually, but there are several practical problems to this approach, depending on where on your career path you are, how much you are planning to save, and what asset mix you are going for. For those with rental or real estate income as part of their “fixed income” allocation rather than bonds, Dr. Networth wrote an excellent piece on how to structure real estate income in relation to your corporation.
Potential Problems Restructuring:
- Insufficient RRSP room: You are limited to a maximum of $26K/yr indexed to inflation and you need to pay a salary of $145K/yr to get that. It is also not retroactive – so, if you have paid only dividends and are mid-career, then you will have even less space.
- Insufficient TFSA room: You are limited to about $5500/yr going forward. The good news is that you may have unused room accumulated depending on when you turned 18. Still, in 2018 it is limited to a max of $57500 (double if you are married to a spouse of similar vintage) plus whatever growth you have had. If you have kidadults, you could even shelter some money in their TFSAs and help them start growing their TFSA room – just don’t count on getting it back.
- Suboptimal TFSA Usage: When you are young, there is an argument to put growth oriented assets in your TFSA. The reason is that it will increase the contribution room of your TFSA more. You could then have more fixed income in there when you are older and want more.
- Equities can produce income: Most stocks and products built from stocks, such as exchange traded funds (ETFs) or mutual funds, will pay dividends. Dividends count as passive income. If you have high dividend paying products or a large portfolio, then this income could blow you off course into pirate infested waters.
- Realizing Capital Gains: When restructuring, like when rebalancing, you would want to minimize realizing capital gains and triggering tax on them now. If possible, it is often better to build up other accounts or asset classes to bring them up to size instead. This is difficult if you are dealing with a massive imbalance.
In general, those starting out fresh with modest savings rates can build a portfolio over time with some minimally embarrassing dance moves like salary, TFSAs, and RRSPs.
If they are earning and/or saving huge amounts, then they will need some extra strategies to deal with potential difficulties in restructuring their portfolios.
They will need the self-confidence to dance like no one is watching. Nowadays, that shouldn’t be too hard. No one is watching… they are all checking their cell phones 😉
It will be important to have a basic understanding of these more daring dance moves for all high income professionals because they all come with different risks and costs. These will need to be weighed by those using them. Further, some of them come with commissions and fees that could influence what is offered or promoted. For professionals that do not benefit, it will important to be able to identify that if they encounter pressure to buy unhelpful products.
We will explore some of those more advanced tools and strategies to repel the tax pirates if you wander into unfriendly tax waters in my next post.