Federal changes to small business taxation have created new rules that cause professionals and small business owners to pay more tax on their active business income, if their investment income pushes them into the penalty zone. It is like the Neutral Zone in Star Trek – not a place that you want to end up in. This space between the conflicting Romulan Star Empire and the Federation of Planets is a dangerous one.
In Part One of Into The Neutral Zone, we described the gross effects of the new passive income tax 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 Canadian Controlled Private Corporation (CCPC) 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 business 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 a doctor investing over the long span of their career?
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. 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.
If they had a higher savings rate, then they would grow a larger nest egg, but would also wander into The Neutral Zone earlier. This means that it could now be bad to be a good saver.
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. Plus, they have to pay for it themselves. That said, they have a snazzy lifestyle.
They start out paying the general corporate 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 small business investment income tax 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. To keep these model cases simple, I ignored:
- Inflation: It would eat away at the buying power of your savings.
- Tax 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.
- Pushing active income into the general corporate tax rate also generates the ability to pay out eligible dividends at more favourable tax rates. This lowers the personal tax bill and that increased personal cash flow rate could be re-invested. That would attenuate the over impact on retirement saving.
Overall, these factors would mitigate the detrimental effects of the new rules by about 5-7%, depending on inflation, how you pay yourself, and how you re-invest money outside of your CCPC account. I tried to keep these analyses simplistic for illustration, but will do more detailed posts later.
However, they still illustrate four key points:
- The affects worsen with higher income.
- The affects start to hit harder later in one’s career.
- How you invest within your corporation makes a big difference.
- These docs had modest savings rates, but they were still able to build retirement savings.
Overall, a trip to The Neutral Zone is undesirable, but it is more like…
What about evasive maneuvers?
There are strategies to avoid the new passive investment income tax 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. There are some simple moves to avoid the new tax. For those professional still impacted, there also some more advanced strategies to reduce taxable investment income in CCPC.
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!