Today, we bring you another live episode, this time from the Annual Canadian Physician Financial Wellness Conference. We answer a series of compelling audience questions — drawing on information from past episodes — that meaningfully impact both sides of the client-advisor relationships. To kick things off, we break down the best time to incorporate, the downsides of incorporating too early, getting money out of your corporation tax efficiently, and common misconceptions around tax efficiency. Next, we discuss the changes in capital gains tax and if it still makes sense to incorporate despite the increase, whether you should pay debt or invest as you juggle all your different priorities, and when to take dividends versus salary. We also get into the topic of corporate bloat and how to address it through measures like smoothing out consumption, why you need to know your notional account balances, insights on dividend-paying ETFs, and advice for alternative investments, including real estate. To close, we discuss how you can determine when you’ve reached financial independence and how a professional financial planner can help you make that call, along with a few final audience questions. Join us to hear the full scope of today’s conversation on navigating the ins and outs of getting incorporated, tax efficiency, and much more!
[0:00:02] BF: Welcome to the Money Scope Podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, Portfolio Manager and Head of Research at PWL Capital, and Dr. Mark Soth, aka The Loonie Doctor.
[00:00:17] BF: Welcome to Episode 17 of the Money Scope Podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, Portfolio Manager and Chief Investment Officer at PWL Capital, and Dr. Mark Soth, aka The Loonie Doctor.
[00:00:31] MS: We’re doing this episode live from the Annual Canadian Physician Financial Wellness Conference, which is a virtual conference that’s put on every year. We’re going to be answering some audience questions, drawing from some of the information of our past episodes. We had a lot of questions submitted before the conference. We recently did another similar type of summary episode at a financial planning conference. But what strikes me is that the information that we give really has a big impact on both sides of the client and advisor relationships.
If you’re a DIY investor, then you’ll obviously benefit from this information. If you’re an advisor, you’d also benefit from it. There’s things that we’ll talk about that you should raise with your advisor or accountant if you have one, even if they don’t bring it up. Because there’s things that they may not realize they don’t know that you can actually use to impact your situation.
[00:01:19] BF: Yes, definitely. We know that a lot of advisors are learning from this podcast as well because we’ve heard from them. Now, if you have been listening to the podcast, you’ll be aware that we have not done an episode in a while. Even the one that we did at the Financial Planning Conference, we have not went around and published it yet. So we just want to mention, don’t worry, we have more highly invasive procedures planned for topics like insurance in a corporation, pension plans, tax and estate planning, and retirement planning.
We’ve been busy building tools like we did at PWL. We built a pretty cool compensation optimization tool based on a lot of the research that came from Money Scope. We’re working on new modeling like that for the next topics. It’s a lot of material. It goes pretty deep. It really gets into areas that haven’t been analyzed at this level before by anyone. We’re really breaking new ground on a lot of cases, which as we’re finding out is pretty time-consuming. So it is taking us a while.
But as I mentioned, we know it’s impactful because we’re hearing from DIY investors. We’re hearing from physicians and other professionals. We’re also hearing from other people in the financial planning industry that they’re really being impacted and appreciating the content. So all that to say, we will have more new stuff coming out soon.
[00:02:28] MS: Yeah, we just really want to make sure that we get it right. The reason why there often isn’t much written or researched about this is because it’s actually complicated, and you can’t just come up with a cookie-cutter answer for it. It’s usually a cross of knowledge on investing and taxes, earning and spending, and they all interact with each other. It’s not just like even a spot in time. It requires attention to the present and the future. What goals you actually have and what you’re trying to achieve will change the way that you approach these problems. Whether you want to leave more money for a charity, or your family, or spend more while you’re alive, all of this impact the best strategy for your situation. It’s been hard from that end. So what we’re going to do is go through a bunch of questions that were submitted to us pre-conference, and there’s some really good ones with high-yield answers.
[00:03:15] BF: Dr. Steph mentioned that we’re going to have some kind of Money Scope highlights of the year and answer common questions that came up from the audience. Those two things kind of end up overlapping a ton. I mean, all the common questions were definitely some of the most popular topics. So we just took the questions and organized them a bit, and we’re going to base the episode on that.
The first one, any specific advice on when exactly to incorporate? Are there calculators to help with this? As an early career MD, should you fill up TFSA, RRSP, registered accounts more generally, or pay off your mortgage, or keep as much money in the corp and invest from there? Super common question. And this is really one of the first questions that professionals who can incorporate like physicians and some other professionals, one of the first questions they have to grapple with is whether they should incorporate. Just because you can doesn’t mean that you actually should.
There are some cases where a small business probably should incorporate for liability reasons. That’s not what we’re going to focus on. For professional corporations, which is relevant to this audience, the main benefits are going to be related to smoothing personal income and managing taxes. Mark and I both often see people advised to incorporate earlier than they probably need to be, at least in our opinion. And the main downside of that is unnecessary costs and complexity early on in a career.
One common misconception that I think feeds into that is that corporations get special business write offs from a tax perspective. They don’t. You can claim the same business expenses whether you’re incorporated or not. I think another misconception that feeds into this premature incorporation is that corporations are more tax-efficient for investing. That’s another misconception, generally speaking. It can be more tax-efficient and benefit from tax deferral compared to investing in a personal taxable account. But your personal registered accounts, your RRSP, and your TFSA, and your FHSA, maybe the RESP, depending on your situation, those are going to be more tax-efficient than a corporation most of the time.
And the RRSP even has complete tax deferral, whereas the corporation is only a partial deferral, because you’re only saving on the personal portion of taxes. And then the FHSA is even more interesting depending on how you use it, because it can be used to completely eliminate tax, because you get a deduction when you contribute. And if you use it to purchase a first home, there’s no tax on the withdrawal.
And then a TFSA, well, it doesn’t have tax deferral. You’re making post-tax dollar contributions. The future growth in the TFSA, because it’s tax-free, typically, when we model this, pulls ahead of the corporation in the long run. Even though you’re taking that upfront tax hit, the rate of growth is higher such that it’ll outpace the corporation given a long-time horizon, which, of course, somebody early in their career has. That’s why the common advice to max out your registered accounts before incorporating typically makes sense. At least, that’s our view.
[00:05:59] MS: Another common question that comes up that may also be a symptom of premature incorporation is all in the lines of, “My personal credit is really high for my training and it bubs me. I have all this money in my corporation now. How do I get that out to pay it off? And how do I do that tax-efficiently? Or how do I get money out of my corporation because my old beater car that I’ve driven for 15 years is now required replacement? Or I want to make a down payment for a house.” And you have much money in the corporation that you’ve left there, but you don’t have any personal money to take care of all these personal expenses.
This is what the reality is when you’re starting out as a physician often is you have all this delayed gratification for many, many years. So in addition to having to have personal cash flow to make up for neglected tax-sheltered accounts like your RRSP, et cetera, you also put off a whole bunch of spending. And you have to be honest with yourself how much you’re going to need to spend over your first years of practice. And if you’re spending a lot personally to make up for some of that delayed gratification and repay debt, then it may not make sense to incorporate right away. Because you do have to get the money out of the corporation, pay tax on it. There’s no way around the fact that you have to make personal income tax, get personal money.
You may want to wait till you’re not just flowing everything that you earn through your corporation to spend personally. Because if you’re just flowing it through the corporation, that’s actually tax-inefficient when you take into account all the different layers of business and personal tax that’s there.
[00:07:23] BF: I want to talk about the tax efficiency, but I also want to just point out that I’ve definitely seen some, I don’t know what I call it, maybe mental accounting here, where when someone does have a corporation, they’re reluctant to spend. And so, you mentioned some examples, Mark, where it might actually make sense to have high personal expenses early on. But I’ve seen cases where people just don’t want to take the money of the corporation because they don’t want to pay taxes. And it ends up impacting their lifestyle. You have the money to spend even though you have to pay tax. I don’t know if you noticed that too, Mark.
[0:07:45] MS: Oh, yeah, totally. We’ll talk about this later. But it has to come out sometime. You’re better off doing that in a way that’s going to benefit you smoothly over time than making irrational decisions and saving it all in there for later when you’re going to pay more tax on it than not be able to use it as well.
[00:08:01] BF: Back to the tax efficiency misconception, I think people see either the lower tax rate on dividends. Because you pay less tax on a dividend than on salary personally. Or the lower tax rate on business income. Because you pay lower tax on active income earned inside the corporation. You look at either one of those in isolation and it’s like, “Wow, this is way more tax-efficient than earning the money personally.”
But you’re paying both levels of tax. You own the corporation. You’re paying the corporate tax. When you pay money out personally, whether through salary or dividend, you’re paying personal tax. And that’s called tax integration. When you add the two sides up, it’s usually more costly from a tax perspective to flow money through a corporation than if you had just earned the income directly. I think that’s a big misconception. That it’s more tax-efficient to have a corporation. It’s typically less tax-efficient. That’s called a tax integration inefficiency.
I want to come back to the debt aspect that often drives some of the early career questions. If you’re incorporated and your debt doesn’t bug you psychologically, then paying it off slowly by taking a little bit extra out of the corporation slowly over time is usually going to come out ahead. That’s usually what’s going to look the best. We modeled this for accelerated mortgage payments back when interest rates were super high. You would need a really high interest rate. It was around 8 % or maybe even a little bit higher for that to make up for the loss of tax deferral from leaving money in the corporation. Because when you take more money out, you’re paying more personal tax often at an increasing tax rate because of the way the personal taxes work in Canada. We did a whole case on that in episode five, debt dilemmas, in the case conference.
[00:09:31] MS: When we did that, the thing was the numbers were still pretty close, whichever choice that you made. Our conclusion was it really comes down to your comfort level with the debt. And that should probably be your primary driver when debating whether to take money out of a corporation to pay that off or not, whatever that debt is. And doing it smoothly is going to be more tax-efficient. And that income smoothing could be another reason that you’d want to incorporate early.
For example, if you have wildly fluctuating business income on a year-to-year basis, and that can happen when you’re trying to get a practice up and running, it doesn’t always just happen instantaneously, the amount that you’ll pay in those high-income years will be the highest marginal tax rates, which are disproportionately higher. And then you won’t make up for that in years where you have a lower income.
And you may have low-income years as well. I mean, the most common reason for low-income years is taking time off due to health issues, or family issues, or sabbatical. Those can happen at any point in your life. And early on, one of the common reasons that is taking a parental leave. Taking where you have very little income. Having a corporation could help you smooth that income out and take some of the income that you would have had in that high-income year and paid a whole bunch of tax on it instead of paying all that tax on it, paying it out gradually, including the year that you’re off work so that the tax rates overall are in lower tax brackets and it smooths it out. You can be more consistent with that.
[00:10:51] BF: And I think even beyond lumpy consumption early on in a career, that idea expands more generally over the long term. I think the corporation’s main benefit is income smoothing over the lifespan, particularly for high earners. It’s kind of the same concept that Mark was just talking about. But you run that through your whole life, it makes a pretty significant difference. And the big driver here is that net income earned in a corporation is taxed somewhere between 10% and 27 % depending on the province and whether the corporation has access to the small business limit. That’s typically going to be lower than the personal tax rate, especially of a high-income earner.
Taking money out of the corporation does still result in personal tax. As we mentioned, when combined with the corporate taxes already paid, that results in an overall tax bill similar to having earned the money personally, often a little bit higher. That’s the integration inefficiency. But the big benefit of the corporation is that it provides an option on the timing of paying the personal portion of taxes. You get to defer those until you take the money out personally.
And then in the interim, investing the after-corporate tax but pre-personal tax dollars in the corporation and then taking it out as dividends later, it’s got two effects. One is that the money that would have been paid in personal taxes stays invested and it’s compounding over time. Plus, when the tax is paid, it’s often at lower personal tax rates if your retirement income is much lower than while you were working, which is often the case. That’s smoothing out your income over your lifetime. Then an added benefit is the flexibility to split dividend income with a shareholder spouse after age 65, which further supports the likelihood of a lower tax bracket later in life.
[00:12:20] MS: Tax deferrals beneficial for that keeping money invested part. But if you can defer tax for a high tax rate now, and then when you do pay tax pay to the lower tax rate in the future, that just boosts it even further. Being able to dividend split, if you’re able to do that before the age of 65, then that would be another reason which you might consider incorporating early if you had a low-income spouse. It actually does work for the business enough to be able to income split with dividends. Because that doesn’t have to necessarily be at a market rate like salary does. Although, it’s quite difficult to do that now for most physicians after the tax on split income rule changes of 2018.
Just to summarize that, if a corporate owner is not able to dividend split with a spouse, and if they’re not able to retain earnings inside the corporation to invest because they’re busy trying to top up their non-restricted accounts and catch up for some spending, then a corporation is much less beneficial. And in that case, there’s usually no rush to incorporate until you’ve taken care of it so that you can deal with those things.
[00:13:19] BF: Another one that comes up that’s pretty interesting, Mark, and I spent a lot of time crunching the numbers on this too much time. I think I’m still recovering from that.
[00:13:27] MS: It causes us to develop really good models that we can now use for everything else.
[00:13:30] BF: That is true. It’s resulted in a bunch of innovation. We’re referring, of course, to the capital gains tax increase that we’ve had in Canada. Is it still worthwhile to incorporate after the capital gains tax increase? We mentioned earlier that registered accounts are better from a strictly investment standpoint. That’s always going to be true because you’re not paying tax on the investment returns inside of those accounts.
I think the more relevant comparison is to a personal taxable account. If you’ve maxed out your registered accounts, now you’re choosing between should I invest in my personal taxable account or should I incorporate? That’s really the relevant comparison here. Now the recent tax changes gave personal taxable accounts some advantages actually over corporations with respect to realizing capital gains. There’s a bit of an exemption personally where you don’t have to pay tax at the new higher inclusion rate. Corporations did not get that. That’s where the question comes from. Does it still make sense to incorporate?
The corporation still has a couple of pretty meaningful advantages. The biggest one being tax deferral. We already mentioned the larger initial capital from having deferred the personal portion of taxes. That compounds over time. And it eventually overcomes the integration inefficiencies that we’ve talked about, especially at long horizons.
One of the things that surprised us when we started modeling this, when these changes were happening, was how powerful the tax deferral continues to be even with the higher capital gains inclusion rate for corporations. There’s still an advantage when we model it because of the tax deferral. We did see that on estate planning, on death, there’s a pretty big hit that comes from this, the new higher capital gains tax rate. But in terms of retirement outcomes, because a lot of that tax is still being deferred throughout your life, there was not a huge impact.
[00:15:09] MS: I think the other advantage that is sometimes not understood between comparing a corporation versus a personal taxable account is that if you need enough money to live on anyways, which most of us do, that justifies paying enough dividends to keep your corporation relatively efficient. We’ll talk more about what we mean by that later on. But if you’re paying dividends out of your corporation because you spend that money, the corporation investment can actually be pretty tax-efficient because the net tax to the corporation is pretty close to the lowest personal tax bracket when you account for that flow through. So as long as you keep it flowing, it can be actually very efficient. Then that gives you a lot of growth over the years where, yes, you’re going to take a bit of a bigger tax hit when you sell and realize the capital gain. But all those years in between, unless you’re in a very low tax bracket personally, the corporation actually could potentially be more tax-efficient during that growth period. We’ll come back to that some more when we talk about optimal compensation.
Just to come back to this game, should I pay debt or invest? That’s another very common question is another variation of this juggling all the different competing priorities that you have. And Ben had already touched on that with the question about when to incorporate versus paying off a mortgage faster. But the same principles apply to other personal debts. And just to give my quick take on that, this may be someone who’s not incorporated, but they have all this unused RRSP room and TFSA room, room. When you look at those tax-sheltered accounts, because it’s tax-free and all the other benefits that go with it, generally, it makes it an easier comparison against interest savings from paying debt faster.
The MAC often works out favouring investing in that situation as long as you’re able to invest in a low-cost, diversified way in something that has a high long-term expected return, that’s likely to be the mathematically superior option. It could be relatively easy to do using something like an all-in-one equity ETF, for example. But you also have to not fiddle with it. And you have to not fiddle with it because you’re nervous. And it’s much easier to be nervous when you have debt there that’s bothering you. I think the emotions here really play into that.
And, yes, there can be some good reasons to contribute to these accounts in addition to the tax-sheltered investing, like for an RRSP and a TFSA, they may help you boost your cash flow because you get that tax refund. That might allow you to not only start investing, but take that tax refund and use it to either invest faster or to repay some of that debt and be able to do a little bit of both.
But a few things are important with the emotional piece. One is that repaying debt is risk-free. And that is an investment decision actually. You get a risk-free return like that if the interest rates are pretty high. That could be pretty good no matter how you look at it. But it also feels good. It makes you feel less nervous. It gives you wiggle room absorb unexpected cash flow shocks. And those are all really important things. Because you have to be financially secure and feel financially secure to invest aggressively.
And you have to be able to do that consistently over a long period of time for it to work out. And if your debt is making you jumpy and making you less well-behaved of an investor, then you really need to be attending to the debt. My first recommendation is to repay the debt to a level where it doesn’t bug you much. And you can also absorb unexpected expenses. You need to feed your delayed gratification beast every once in a while, a few snacks. Otherwise, it’s going to poke its head out at a bad time and all those things can throw you off your plan. Just trying to avoid spending on things that are going to have a lot of ongoing costs that go with them.
Once that debt is at a comfortable level where you have a stable platform, the next step is to max out those tax-sheltered accounts. But the reality is you’ll probably do a bit of all of these things. You’ll repay some debt. You might use the refund from RRSP or an FHSA to help you further. You’ll get value. You’re doing some investing. You’ll also repay debt faster. You have to reward yourself along the way. Keep yourself motivated to be doing it all.
Once all that’s done, and then you have extra personal money to invest, that’s really where a corporation becomes quite powerful as an option. And it’s important to know that getting there may take several years. It could be very discouraging when you’re starting it. It feels like you’re spinning yours a lot. I had a lot of very good circumstances when I started my practice, but it still took us five years before we started to save any appreciable money within our corporation.
[00:19:28] BF: It’s common for people to want the optimal solution to this. How much of my debt should I pay down? How much should I put in my RRSP? You can find that solution based on assumptions about the future. But then, boom. All of a sudden, capital gains, tax rates change. And it’s like, “Oh, now that perfect plan that you put in place is no longer perfect.” I think a lot of this is really what you said, Mark. What makes you comfortable? The approximately right solution is going to be better than doing nothing all the time.
[00:19:51] MS: The whole point of money is to make our lives better. It has to make you feel comfortable.
[00:19:55] BF: You got to feel good about it. And there’s no point agonizing over the details down to the dollar of which money should go where. Because, like I just said, even if you figure out the absolutely perfect calculation for how much you’d go where, that could change tomorrow based on tax rates changing or whatever, some other thing changing. That’s worth keeping in mind. Analysis paralysis is common with smart people trying to make good decisions. But the paralysis can often end up being harmful in the long run. Another question where I think analysis paralysis also comes up, this is a big question, under what conditions should I take dividends versus salary? Whoa.
[00:20:30] MS: That puts this into a rabbit hole for bunts on Excel.
[00:20:32] BF: Many months. Optimal compensation strategy for business owners. This is a big topic. And I don’t want to give ourselves too much credit here, but until the work we’ve done together and until Money Scope, I couldn’t find the information on the internet before we did this. I don’t think anybody had looked at this the way that we have. But before talking about optimal compensation though, we have to talk about corporate notional accounts. These are accounts that exist to achieve tax integration. They’re not real. They’re just tracked on paper.
We’ve got refundable dividend tax on hand, RDTOH, general rate income pool or GRIP, and capital dividend account or CDA. Lots and lots of acronyms. But it’s all because when a corporation has taxable investment income, it pays tax at a rate close to the highest personal tax rate. But a big portion of that tax is refundable when a dividend is paid to a shareholder. And again, this is all to achieve tax integration, to achieve indifference between earning money personally versus earning it in a corporation. It doesn’t get there perfectly, but it’s designed to approach that.
I’m going to circle back there. A portion of the tax is refundable when a dividend is paid to a shareholder. So that’s non-eligible, refundable dividend tax on hand and RDTOH. When a corporation receives an eligible dividend, so if you have a corporation, you invest in a Canadian company and you receive a Canadian eligible dividend from that stock, that creates ERDTOH and GRIP. When a corporation pays tax at the general business rate, that also creates GRIP. So when you pay tax at above the small business rate in your corporation on your active income, that also creates general rate income pool.
GRIP is the notional account that allows the corporation to pay out eligible dividends, which have a lower personal tax rate. And then finally, when a corporation realizes a capital gain that creates CDA, capital dividend account, which is the part of the capital gain that is not subject to tax and can come out tax-free as a capital dividend to a shareholder. When the flow of dividends from a corporation is functioning well, which means consistently releasing the RDTOH, a corporation can have an annual tax drag similar to investing personally at the lowest tax bracket, which is pretty cool.
Maintaining that state that requires a lot of attention to how the corporation invests and also using the right mix of salary and dividends. This is why we had to do that preamble to talk about the optimal compensation decision. If insufficient dividends are used to release RDTOH, if you’re not releasing all of your RDTOH, then the tax drag in the corporation ends up being roughly equivalent to the highest marginal personal rate. Now we’ve just gone from being pretty tax-efficient to being, whoa, pretty tax-inefficient. Mark has a pretty funny name. I think it’s funny anyway. For what happens when a corporation’s RDTOH builds up.
[00:23:12] MS: It’s one of those situations where if you don’t let it out, bad things happen. And we have a lot of those in medicine. I coined it as the term corporate bloat for that situation. And really it can rise when RDTOH becomes trapped inside the corporation until you release it. And when could that happen? Well, if you don’t need extra cash personally and you have a high rate of RDTOH building up within the corporation and taking extra dividends out just to release the RDTOH, well, if that’s at a higher tax rate than the refund that the corporation gets, then basically it would make paying a dividend solely for the sake of the refund inefficient.
You have this situation where unless you change something, you’re going to have buildup where you’ve prepaid tax at the highest personal tax rate until you get money out of the corporation. And that’s on purpose. I mean, that’s designed to prevent us from building giant corporations of all this deferred, tax-deferred money. It’s unpleasant. And the reason why it’s unpleasant is because you’re paying that high personal tax rate upfront until the excess gas is released out. That can happen with any kind of investment income when it starts to exceed what your spending is personally. It can also happen just by the amount of income that’s in the corporation. It can happen if the corporation starts to exceed the passive income limits. That’s that limit of $50,000 a year that they set a few years back.
And if you have more than $50,000 a year of passive income in your corporation, that causes a jump in the corporation’s overall tax rate potentially. It shrinks the small business deduction threshold. And if you make enough active income within the corporation, that starts to get bumped up from lower rate to the higher rate, which is roughly a 15% tax increase. But it also occurs at a five-to-one clip. Every $1 passive income increases that active income, that gets bumped by five. It’s more like a 75% tax increase when you consider it that way.
Similarly, it’s relieved by passing money out of the corporation using eligible dividends from the GRIP that gets generated. So when the corporation does get bumped up at that higher tax rate, that active income taxed, the higher rate generates GRIP, which is what allows your corporation to pay out eligible dividends that have that lower personal tax rate. That is not perfect, that integration of eligible dividends and general corporate tax rate business income. But it does take it down quite a bit. It does eliminate it, but it smooths it out of most provinces.
There is one possible exception here, which is if you spend enough money to use all of that generated. There is a little bit of a nuance in Ontario and New Brunswick, just because the corporate tax rate didn’t follow what the federal one did, where there actually could be a small benefit from going over the passive income limit. But it’s otherwise a penalty. When you put that together, all that means is that really some proactive planning to help prevent corporate bloat is probably important. And being thoughtful about compensation when bloat actually is occurring becomes critical.
Generally, looking for ways to flow money out of your corporation tax-efficiently and prevent it from growing more quickly than it has to, and when it is getting large to get the money out efficiently. There are some things you can try to do to slow that down or to relieve it. Simethicone for your corporation.
Paying salary and using registered accounts
[00:26:26] BF: Let’s talk about one of those treatments, which is paying salary and using registered accounts. Mark and I have both seen lots of cases where people are advised to only pay dividends from their corporation and retain as much as possible inside of the corporation. Now, there are lots of reasons that people give for doing this, including the perception that dividends are more tax-efficient, which is often not true when you account for both sides of the tax, as we’ve mentioned. And the paying dividends avoids the need to pay into CPP. That’s a whole other rabbit hole. But in reality, dividends are typically less tax-efficient than salary. And paying into CPP is actually probably a really good idea for most people. Episode 14, we did a deep dive on CPP and EI for incorporated business owners.
One of the big benefits of paying some salary, especially early on, is that it can help delay the onset of corporate bloat. Paying salary moves money efficiently out of the corporation. Because salary is efficient. And it generates RRSP room, which is really valuable. Making RRSP contributions reduces the personal income tax, and it gets money growing within a tax shelter instead of in the tax-exposed corporate account and contributing to corporate bloat.
The other really interesting thing about salary, and this in the modeling that we’ve done is even more interesting now with capital gains tax rate changes or inclusion rate changes, a history of salaries near corporation opens the door to using an IPP or an individual pension plan. And that can be used to shift even more money out of the corporation into a tax-sheltered environment. And that starts to make sense typically when the business owner is in their 40s. That’s when the room in an IPP exceeds the room you would otherwise get within RRSP. But that’s more beneficial if you have a history of salary using the IPPs. We found IPPs to be pretty interesting before the capital gains inclusion rate changes. After those changes, they’re even more interesting. Because investing inside the corporation became a little bit less tax-efficient and just makes the IPP that much more interesting.
Low tax bracket personal investing
[00:28:17] MS: Using money to spend and fund your personal consumption, you’re going to have to do that anyways. Doing it in an efficient way like that, especially using salary early on, really helps you to do that and build up some of your other accounts. There are some other less common cases where it couldn’t make sense to move extra money out of the corporation even if you don’t need it to spend. Taking that extra money and then investing it personally.
One of the times where that could make sense is if you have a very low-income spouse who has a very low tax rate and you’re able to get the money out tax-efficiently using one of the methods that we’ll talk about. That can allow you to invest that money. Have it grow forward in that personal account. Potentially the lower tax rate each year. But also, when the capital gains are realized, if they’re realized personally, there’s now this $250,000 a year threshold. Personally, when there is no threshold, the corporation to have a higher tax revenue capital gain. It used to be pretty much you had to really be in the lowest tax brackets at a very low income for it to justify taking out any extra money from a corporation. It’s kind of edged up a little bit. So you might be into still pretty low tax brackets, but not necessarily the bottom tax bracket anymore when you count for how it unfolds over time. If those very low-income levels, it depends on how you’re investing too. At very low-income levels, if you’re having eligible dividends, those might be a little bit more efficient personally.
There’s all sorts of different factors that come into play, but really the big key is how do you get that money from your corporation out efficiently into your personal hands? Because taking a big upfront tax hit to get money invested personally generally doesn’t make sense. It has to be that you’re taking advantage of an opportunity to get it out efficiently. There are ways to do that. We’ve mentioned capital dividends already. If you realize capital gains in your corporation for rebalancing your portfolio or if you donated, appreciated securities to a charity, that’s even more powerful for generating a balance in your capital dividend account, which allows you to move money out tax-efficiently.
And one of the things about capital dividends is if you have a non-voting shareholder lower income spouse, you could potentially give them a capital dividend and it wouldn’t cause attributable income, so they could invest in their lower taxed hands moving forward. There’s all sorts of nuances there. We made this optimal compensation algorithm, which we also have been fine-tuning over the last year or so. And we’ll talk about that some more in a minute.
Smoothing Consumption
[00:30:41] BF: Another idea is smoothing consumption. We mentioned how corporations can help to smooth out income over the life cycle. One of the ways to address corporate bloat is to look at the other side of the equation and smooth out your consumption. Corporate bloat happens when you’re earning much more than you’re spending. Now, that’s key for investing. But at some point, it can make sense to work a little bit less, to spend more time on maybe less financially rewarding, but more enjoyable work. Or even increase personal spending more, particularly on experiences or things that bring joy and satisfaction.
[00:31:10] MS: All of those factors really actually are part of what fits into an overall compensation plan. It’s not just about knowing about taxes. It’s about how do you use that in your overall life? If you have an overall compensation plan that accounts for the fact that there’s gonna be inefficiencies of keeping too much in the corporation while spending too little and recognizing that the money has to come out eventually, as preferably in a controlled way at a good time, rather than an unplanned way, then you can make these plans to smooth consumption over your life span.
There’s probably this optimal balance between working, and saving, and spending, and paying taxes over your lifetime. No one’s going to be able to decide that in advance. But it’s one of those things that if you think about it, you can find and make adjustments along the way to try to move yourself closer to that as time goes by. Or get yourself back aligned if you shift it out of alignment because your life’s changed. And developing corporate bloat could be one of those important cues for you to stop and say, “Okay, maybe I should consider my overall future plans and my current plans and make some adjustments.”
[00:32:14] BF: If you don’t make adjustments, you’re going to end up spending more just on taxes instead of on enjoying your life. It’s a really important tradeoff to manage. Another way to prevent and treat corporate bloat with limited downsides is to use what we’ve called optimal compensation. This is, I think, a pretty cool idea. Maybe it’s the engineer in me that likes it. But it is pretty neat.
Mark and I worked on this kind of in parallel. We were both working on it. And we started emailing each other and realized we were kind of working on the same stuff. I looped in Braden Warwick at PWL who is literally a rocket scientist. He’s got a PhD in mechanical engineering. Used to work on aircraft. But he joined PWL to work on financial planning modeling, which is pretty cool. We were all kind of working on this idea of optimal compensation.
And so, the idea is we can kind of treat it like an engineering problem. Rather than just paying salary or dividend compensation every year, which is a common advice. Some people will say, “Well, just pay yourself dividends. Or just pay yourself salary. Or pay yourself salary up to whatever, $60,000, then pay dividends.” There’s all kinds of rules of thumb like that. But our idea was there’s probably an optimal mix every individual year of salary, eligible dividends, non-eligible dividends, and capital dividends. There’s probably some optimal mix that maximizes lifetime wealth and consumption while minimizing tax drag. That’s what we kind of did. We approached this like an engineering problem and tried to solve that equation.
And it really turns the age-old salary versus dividends debate that’s been going on forever. Should you pay yourself salary or dividends? It really turns that whole thing on its head. It’s not one or the other. You shouldn’t be thinking salary or dividends. You should be thinking in each individual year how should you be paying yourself and realize that it’s going to change over time.
The way that we’ve approached solving this is by developing optimal compensation algorithms, which we’ve tested extensively. Mark has built algorithms. PWA has also built algorithms. We have a bunch of algorithms that run in parallel because they work differently under different circumstances. We run the wall concurrently and then we pick the best one. And you follow that one just to think through it.
Generally, salary has the best corporate and personal combined tax rate, and it has the big advantage of creating RRSP room. Those are big points in favour of salary. But then as the corporate investments grow, dividends are required to release the accruing RDTOH that we’ve been talking about. Realizing capital gains in the corporation creates a credit to the capital dividend account, which can be paid out tax-free. Dividends being slightly less tax-efficient than salary, when the RDTOH release is accounted for, it can be more efficient than salary. If combined with salary, the required dividends to release RDTOH create more income than is required to live, that may mean taking less salary over time.
When we model this out, typically what we see for a corporation that’s starting out that doesn’t have any investments to begin with, because if you have a lot of investments, typically dividends make more sense because it releases the RDTOH. But starting out a corporation with not much in it, typically what we see in our modeling is a lot of salary upfront, which is great. It’s efficient. It creates RRSP room. It gets CPP credits. But then salary decreases over time in the optimal compensation outcome as it gets replaced with RDTOH releasing dividends. But it is pretty neat to see in the modeling how the optimal sources of compensation change over time.
[00:35:27] MS: That’s how it works out for most people. It’s hard to come up with just one rule of thumb. But generally, that’s how it works salary and then gradually more dividends. There could be a few other things that could make you move more towards one or the other over time. There’s just too many variables for us to talk about today.
Then there’s also the opportunities that can come up if you just happen to develop some space in your capital dividend account, which we mentioned before, either by rebalancing your portfolio or maybe switching to a better investment strategy or making some donations to charity. Those capital dividends allow you to shift some money out of the corporation tax sufficiently into personal hands.
We went into a lot of detail in this, actually, in episode number 13 of the Money Scope Podcast. It was a very detailed breakdown of the algorithm that we use. We’ve refined it along the way. With that, because it’s so complicated, we built tools to help us do that. Ben’s talked about that. So I’ve got a salary versus dividend optimizer on The Loonie Doctor site that I use. I have a larger test version of it where I can model it over many years, which I can’t make work on the Internet. But Ben and Braden and the PWL Capital have a version that they use in-house that models it over long periods of time that they use for their clients.
We covered it on the algorithms, and we built the tools in parallel but cross-checked them with each other. We’re in the process of writing a white paper on it as a topic, which we’ll plan to release that out to the public. With all that information there, the main message for you as an end user is to ask your accountant if you have notional account balances. Ask them about RDTOH, your capital dividend account. If you have balance in those, you should be asking them whether you should be using dividends to clear those out and think about doing enough dividends that you’ve got a plan to do that.
If they’re suggesting you just use dividends and not salary, well, you should be questioning that. Unless there’s a lot of investment income that you have already [inaudible 00:37:19] to move out, you should be trying to use some type of salary in the mix. Those are the two biggest things that you should probably take away from all that in-depth discussion. Ask them about those notional accounts. If you’re not taking any salary, you might want to reconsider that decision.
[00:37:36] BF: That’s right. I’ll just repeat because it’s so important. You need to know what your notional account balances are. If you have a large CDA balance or a large RDTOH balance, that really should be informing how you’re taking compensation from the corporation. Make sure that you ask your accountant about that. Make sure every year you’re aware of what your notional account balances are and that you’re incorporating that information into how you’re paying yourself.
I do also just want to reiterate, Mark does have tools on his website that help you figure this stuff out. PWL also has tools. We’re keeping them internal for now. We have started launching some public tools at – I think it’s research-tools.pwlcapital.com. This one is not on there. The optimal compensation one is not on there. It’s a really complex tool. Just the inputs are really complex. Maybe we’ll release it at some point, I don’t know, or a simplified version. It’s heavy.
[00:38:25] MS: You need some basic knowledge to use it.
[00:38:27] BF: That’s the thing. If we just put it out there for the public to use, I’m concerned that it would be used improperly and lead to incorrect decisions, which, obviously, we’d feel terrible about. For now, it’s an internal tool that our financial planners have access to.
[00:38:39] MS: Mine’s out there as a conversation starter for you and your accountant. None of us should be making these decisions by ourselves. But I think we need to come to the table as an educated client with our accounts, particularly in this type of area, which as Ben mentioned, a lot of people have looked at this. There’s a lot of accountants who just have not thought about this in this type of detail and over a lifespan rather than one or two years at a time.
[00:39:01] BF: That whole concept is new as far as I can tell. Next question. This is a common one. For long-term investing within a corporate investment account, is there a role for dividend paying ETFs? That’s a big question. We’re going to answer it from the perspective of tax efficiency because I think that’s often the focus for people with corporations. This is a classic here. It comes up all the time. When you earn eligible Canadian dividends in a corporation, as we’ve mentioned, it creates Part IV tax, which is fully refundable when you pay out an eligible dividend to a shareholder. That makes it look really attractive to have dividend-paying stocks in a corporation. You pay less personal tax because you’re getting eligible dividends out. All the tax that the corporation pays is refunded when you pay the dividend out personally.
Then to just contrast that quickly, interest and foreign dividends, as opposed to Canadian dividends, they are taxed more heavily, especially when passed through compared to being earned personally. Those are all really attractive features for earning Canadian eligible dividends in a corporation. But the problem is a corporation can easily become the largest account in your portfolio. I think in many cases it will. If it doesn’t become that, maybe you didn’t need to incorporate in the first place. It should end up being really large if you’re using it properly.
I think it’s really important to avoid the overall portfolio, and you think about your whole net worth from being overly concentrated. You don’t want that to be overly concentrated in Canadian stocks because you like Canadian dividends so much.
[00:40:26] MS: That’s the key. I mean, it can become a very big concentration in Canada and that relatively small tax savings, which is real. It’s a tax savings, but that’s a relatively small tax savings. It could easily be outdone by Canadian equities underperforming other markets over a long period of time. We’ve seen that in the recent past. You don’t have to look far to have seen that happen. It could do better, too. I mean, no one knows what the future holds. But it’s an uncompensated country-specific risk, and you don’t get compensated for taking specific risks. You don’t expect to be compensated.
You could try to do things where you locate Canadian equity preferentially in your corporation, along with all of your other asset allocation. But that comes with added risks because there’s tax risks, because you’re making assumptions about tax rates. It gets very complex very, very quickly to try to do this asset location optimization. I don’t know that I’d necessarily turn to that as a solution, unless you have a really good easy way that’s effective of doing it.
The other potential challenge with focusing on high eligible dividend payers in a corporation is that it’s also not just the efficiency of flowing it through. It’s the amount of passive income there as well. Canadian equities tend to have relatively high yields, even more so if it’s a dividend-focused portfolio. Your corporation may start to develop a very large amount of passive income relative to what it pays out to shareholders and becomes inefficient, either because of the RDTOH trapping or the passive income mechanism, which we’ve talked about.
[00:41:53] BF: People get pulled in by the tax efficiency. But if you end up with a ton of RDTOH, if you’ve got low personal spending needs and the passive income starts to build up a lot, you end up with a lot of trapped corporate refundable tax, until you do start paying out dividends. That translates to tax drag at a pretty higher rate in the corporation. Then we also have that issue that I think you’re just alluding to there, Mark, about the corporation generating too much passive income, and that starts to drive down the amount of your small business deduction.
If you just look at a quick example, a corporation with a five percent dividend yield in the portfolio, that starts shrinking its small business deduction at about a million dollars. But if you take alternatively a globally diversified equity portfolio with a two percent yield, which is pretty typical, you’ve got until about $2.5 million of investments in the corporation before you start running into that problem of reducing your small business limit. They could have larger portfolios without an impact if the corporation’s active income is lower because you don’t need as much of the small business limit in that case. If a CCPC with $250,000 in net income after salaries, they wouldn’t have a problem until about five million with a diversified portfolio.
[00:43:00] MS: By diversifying amongst different types of investments that have a lower income, overall like at a lower yield just by happenstance rather than focusing on getting dividend yield, can allow you to have a much larger portfolio in a corporation without running into these problems where you have a large corporation and a high passive income. Then you’re required basically to be paying large dividends to yourself to stay efficient. Keeping it up for tender in a recent corporation is important. This comes back to this idea of keeping it all to the corporation, which is common device. It can make it become tax-inefficient, and focusing on high-yield investments can accelerate that process.
[00:43:38] BF: I also want to just quickly say that people get really attracted to dividends because they’re income. They feel like income. I don’t want to get too deep in the weeds on dividends here. But when you receive a dividend, the dividend reduces the value of the share that you own. So a dividend is not actually an investment return. When you receive a dividend, your net worth has not changed. Because you get some income, your capital side, your share value decreases by the amount of the dividend. That has to be true. Empirically, it is true.
People get really excited about dividends and how high their dividend income is. You see people posting about it on Twitter all the time like, “My annual dividend income just reached $70,000.” It doesn’t really mean anything. That’s like saying, “I just started selling $70,000 of my portfolio every year and moving it into my bank account.” That’s great, but it doesn’t actually mean anything. There’s the tax side and then there’s also the income side. I think people get attracted to it at dividends. But in both cases, I don’t think it’s super compelling.
[00:44:29] MS: From an investment standpoint, you’re right. It does a lot that we make sense. I guess you could argue we’ve talked about the tax argument already. The other argument that goes with it, I think people get really, really emotionally attached to the idea of having income because we all understand income. The benefit of that could potentially be that we spend income easier than we sell stuff to spend it.
If you have a problem where you’re blowing your corporation up or your investments, you’re just not going to spend them down. Perhaps having income makes it easier for you to spend some of that money that you should be spending. But, of course, being aware of that, you probably could start to sell things, too. If you have a good system or an advisor that basically is selling stuff for you to provide you that income stream as needed, capital gains are still going to be more tax-efficient than using a dividend-focused strategy because you defer the tax until you realize the game, instead of being forced to pay income tax every year because you got paid a dividend.
Then you also – capital gains, even with the higher inclusion rate, are still pretty tax-efficient qualitative dividends.
[00:45:29] BF: Well, we can talk about dividends all day, but the next question is kind of related. Other than ETFs, what are reasonable alternatives to investing, particularly when one reaches the passive income limit? The second version of that question is what other investments are permitted under my medical corporation?
[00:45:43] MS: A corporation can invest in many things, beyond just stocks, bonds, and funds. I think the question to ask yourself when you’re looking at all of the options out there is whether adding more is going to add value to what you’re trying to do with your portfolio, or is it just adding complexity? With that usually comes fees often paid to the people that are suggesting the more complex strategy that’s there.
Now, one example of something else you can hold in your portfolio beyond stocks, bonds, and funds is real estate. It’s probably one of the most common things that people invest in outside of public equity markets. Real estate can be a great investment, but it comes with transaction and maintenance costs that go with it, too, so it’s not the same as just buying or selling an ETF for free or under 10 bucks. There’s a lot more involved in buying and selling real estate.
You also have to spend a lot more time selecting those investments because instead of investing in a broad index of a whole bunch of different companies, you’re selecting usually a single property, a single address at a time. You’re going to have a much more specific risk with that investment which, again, you don’t really get compensated for specifics.
[00:46:47] BF: The market’s not necessarily as efficient. You really do have to be a lot more aware in that market than you do when you’re buying an ETF.
[00:46:54] MS: Which you can take advantage of if you’re really good at it.
[00:46:56] BF: Correct.
[00:46:57] MS: But you have to be really good at it, and you’re competing against other good people.
[00:47:00] BF: That’s exactly it. The other thing with real estate, I think, is that it can be described as buying yourself another job. It’s a lot of work. You talk to people that actually manage properties. Mark, you and I spoke at an event fairly recently, and we got this question from someone who was like, “We have these properties, and I’m exhausted. Is this what I should be doing?” The answer is probably no one.
[00:47:18] MS: No, and do something else.
[00:47:20] BF: Yes. It’s like buying another job. When you spend time to work on something, including a rental property, there can be economic benefits from doing that. You’re still creating value by working, but it also means taking time away from potentially more profitable or more enjoyable activities. I think this is particularly salient for physicians because they’ve got relatively high rates of pay and basically unlimited working hours. There’s a really clear connection between time and money.
[00:47:45] MS: This is the thing. It’s very popular in Canada as a whole with real estate investing. If you think about what makes real estate good for investing, it really involves around leverage. Real estate is one of the easiest ways that the average Canadian can get access to a big loan. I mean, it’s hard to get a loan to go buy a bunch of stocks and bonds. It’s relatively easy to get a loan against a property. If you’d need leverage to meet your investing goals, then real estate is one of those ways that the average person gets easy access to it.
Now, of course, what goes with that, though, is it magnifies the potential risk along with the potential return, and you do have this specific risk. If market conditions change for specific property or the government targets it for intervention with real estate right now is a very hot target, there’s going to be unforeseen and unintended consequences. Diversification could attenuate that, which is sometimes more challenging to deal with real estate, I would think, just given the size of the transactions that happen.
The same principles that I just mentioned with that also goes with non-real estate private equity markets. You can go and invest in funds that try to buy all companies and other non-publicly traded assets. Again, there are going to be inefficiencies in those markets that a good manager could potentially take advantage of, but our markets are still open. There’s no free lunch. There’s risk and return that are tightly related. There’s a very efficient market for managers, too. What ends of happening is the managers end up pocketing a lot of that advantage that they provide. At the end of the day, you’re left with a very similar type of outcome potentially than what you would have had if you’d been investing in an efficient public market without having your money tied up.
Sometimes, investing some of these areas outside of ETFs or stocks and bonds, they fill other needs for us. We’ve talked from a strictly puritan investment standpoint, but it’s much more exciting to talk to your friends about the startup that you’re invested in or the company buyout or the real estate investment than it is to talk about your boring asset allocation ETFs. I can understand there’s other reasons beyond just the financial reason that you choose to invest in. Just to be careful that if you are going to do that, that you recognize that’s what you’re doing.
The other thing I’d say with private investments, that could be a potential advantage, even though from a risk return standpoint, it’s probably all baked in there, is the fact that they’re priced infrequently. You don’t see the prices go up and down every day, even if you look, which you shouldn’t. It prevents you from seeing that, and you can’t just buy them and sell them on a whim, which you shouldn’t be doing anyways. But the nature of the investment prevents you from doing that. That could be a behavioural advantage potentially, as long as you don’t need the money. If you do need the money, then that’s a big disadvantage. For those that can’t help but fiddle excessively with their ETFs or their liquid investments graph. There are some other non-financial reasons to do it.
[00:50:32] BF: There’s some research that suggests that preference called volatility smoothing, volatility laundering, as some people call it more colloquially. Some research suggests that that actually is priced in. So the fact that people are willing to pay more for that reduces the expected return of those illiquid investments. It’s just an interesting idea.
[00:50:49] MS: If the markets are still efficient, all these things that we think of have been figured out by the market.
[00:50:54] BF: Yes, exactly. There are a ton of asset classes available to investors today easily. You can access whatever you want. I mean, we’ve got crypto, hedge funds, private assets, including equity, debt, real estate, venture capital, GP stakes, a relatively new one. That’s where you’re actually investing in the private equity fund manager instead of in the private equity fund itself. I mean, this just goes on forever.
There are also wrappers like permanent insurance policies or corporate class funds that hold different types of investments. There’s just so much stuff out there, and I think it’s really easy to get compelled to invest in all this exotic stuff. They’re sold in a way that I think appeals to high-achieving professionals. There’s this perception that if you work hard, you’ll be successful. I think physicians have lived that. I don’t think the same thinking applies to financial markets, but it gets sold that way. These types of investments get sold as exclusive or limited access or hard to access.
But the reality is, and there’s a ton of research on this in general, exotic asset classes, private asset classes, they tend to come with high costs, hard to identify risks, which I think is a really important description. Because of their illiquidity and because they tend to be a little bit more opaque, they might be really risky in a way that doesn’t show up until it’s really, really bad.
The other important piece of that is that the research also suggests that there’s typically not anything special there in terms of expected returns that you couldn’t get using publicly listed, less costly, and more liquid assets. My view on this is it’s probably more profitable to get really good at avoiding these types of shiny objects than it is trying to pick good ones.
[00:52:25] MS: It’s hard because the companies that make these, they get paid to make them. Every time there’s some new hot investment trend, you can bet they’re going to come out with some way to try to invest in it because they know that people will buy it because that’s what we do as humans. This is the thing, to bring it back to the corporate bloat thing for a minute, this is one of the ways. This is used as an opportunity for people to try to sell some of these financial products. If you’re having passive income issues in your corporation, someone’s going to try to sell you a product to address that issue.
Or, again, when the capital gains tax change came out, my inbox was flooded with people selling products and strategies. Not to say that they’re all bad. It’s just that it’s very opaque. When you can’t see what’s going on inside, there’s going to be stuff hidden in there because markets really are efficient, and they price this stuff in. The companies that sell that price it in, too, they do that because they know what they’re doing to make a profit from it.
Just to contrast, those products is different than what we’ve been talking about, which is planning and thoughtful long-term thinking, which has limited downside risk and doesn’t have other risks baked into it as much.
[00:53:32] BF: Products are tools. They’re not planning strategies, but they often get sold as planning strategies. Mark, in the interest of time, what do you think about jumping down to one of the later questions? How will I know when I’ve reached financial independence? I think that’s an important one.
[00:53:44] MS: This is a great question. I’ve struggled with this question. Looking at it from my own situation, I keep moving the posts repeatedly. In retrospect, that’s probably not surprising. Most people start off with a very simple approach. If I have some threshold, like 25 or 30 times my usual spending in a stock or bond portfolio, then that’s going to mean I’m financially independent. Part of why that bar is uncertain is because those rules of thumbs are based on historical US data.
[00:54:12] BF: When you look at more global market data, which then this research has been done, I’ve done some videos on it. When you factor in taxes in Canada, you end up having a much lower safe withdrawal rate. That’s this concept that Mark was referring to. I mean, it could be like 50 times your spending to be financially independent, but you got to take that with a grain of salt.
[00:54:31] MS: The good news is that the bar keeps moving lower every year than it should work because there’s one last year of retirement and one more year of working, growing, and investing your money.
[00:54:40] BF: Yes, that’s big. I think the other thing is that those numbers, like the four percent number that people have heard, I did a video where I found that if you properly account for the actual historical experience of edge markets around the world, instead of just the US, the number is closer to like three percent, maybe even a little bit below that, which is really low. You have to have a lot of savings to fund your spending at that level of withdrawal rate.
But all of those things, and I say this in my video on this, they all assume constant spending adjusted for inflation for your entire life. I don’t think that’s realistic, and it’s not smart either. We had Moshe Milevsky in our podcast a while ago, and we talked about the four percent rule. He kind of used the Socratic method to make me say why withdrawing the same amount from your portfolio every year is really dumb. It was very stressful. He got his point across. It was kind of funny.
People adjust their spending based on what’s happening. If you wanted to go on a vacation every year, a big expensive vacation every year, and the market crashed six months ago, you might defer the vacation. I think people actually think like that. The assumption that you’re going to spend the same amount adjusted for inflation every single year just doesn’t make sense. I think one of the big things to consider when you’re thinking about whether you are financially independent is how much fat you have in your budget that you’re willing to trim in bad times. Now, that’s going to be a moving target because your life circumstances and your desires change over time, but it’s a really important number to be aware of.
[00:55:55] MS: Yes. I think that’s part of why it’s really shifted for us, too, is what we spent and thought was important several years ago is different than what we spend, I think, is important now. I’m sure as we age and go through different parts of our life, we’ll be spending different amounts, and it’s not going to be easy to just spend the same thing all the time. It’s going to go up. It’s going to go down. It’s going to change.
I think the big key utility of having a look at what you are for financial independence is having an idea of how much you need to work to provide for yourself and making adjustments to that if you’re up or down based on what your goals are. Also looking on the other side of the equation how you’re spending and what’s important to you, how is that changing, and making adjustments up and down in that side of your life, too. That’s part of why the post may shift back and forth all over the place. The concept itself is still very powerful for you to take your money and have us work for you, rather than you just working for money all the time. You can use it to shift what you’re doing.
[00:56:54] BF: I do want to just finish off by saying that I feel like I’ve got a bit of a professional obligation to say that figuring all this stuff out, figuring out whether you are financially independent is one of the key functions of a professional financial planner. That is one of the things that they are professionally trained to do. Some of you heard from Mark McGrath earlier. He is a financial planner who I work with at PWL, and that is a huge part of his job is helping people figure out whether they’re ready to retire from a financial perspective. Mark is specifically focused on helping physician households do that.
There are also fee-only financial planning firms that do this on an hourly basis or an engagement basis. PWL is a full-service financial planning firm, which means we manage investments and also do financial planning. But in either case, these firms employ CFP professionals who are trained to help people figure out, among other things. Help people figure out whether they’re able to retire and how to most efficiently fund their retirement. Financial planners typically have access to pretty sophisticated software that includes taxes, government benefits, the uncertainty of future investment returns.
William Sharpe, who’s a Nobel Prize-winning financial economist, he has famously said that retirement spending is like the nastiest, hardest problem to solve in finance, which is true, I think. It is hard, but this is what financial planners do.
[00:58:05] MS: I think the reason why people like Ben and I spend so much time on this, even though I don’t provide financial advice, is that you as the person who’s getting the financial advice, you’re going to get more out of it if you understand these other issues that are coming to the table with it. An advisor can only help you if you have a sense of what’s important to you, what’s not, what’s good advice, what’s bad advice. Because there is variability that’s out there, bringing that to the table, I think, really affects the outcome in a pretty big way.
[00:58:33] BF: That’s true. More financially literate households are more likely to seek and benefit from high-quality financial advice. That’s an empirical fact.
[00:58:40] Moderator: It looks like you covered everything from whether you should start to incorporate all the way down to optimal compensation in a corporation, as well as reaching the financial independence phase. But there are some questions that were submitted in the chat that were kind of related to the end of the incorporation timeline. Someone was asking about optimal charitable giving, whether you should do it personally or through a corporation.
[00:59:08] MS: I wouldn’t say it’s necessarily the end of your timeline that you should be thinking about this. Giving to charity is actually a skill. The best way to develop that skill is to do it intermittently over your lifetime and make it part of what you do. When you look at what makes you happy, giving is actually one of the things that gives the most lasting happiness out of all the different things that we spend money on.
Now, the question then is how do you do that tax-efficiently? Generally, doing it through your corporation is going to be more tax-efficient because you’ve got those pre-taxed dollars. I say that generally but not always because really it comes down if you can donate appreciated securities. That’s really the best way to do it. If you can donate appreciated securities, and by that I mean if you have an ETF or a stock or a fund that’s gone up and has a big capital gain, if you donate that from your corporation, you get three benefits.
One, you remove that tax liability, so you don’t have to worry about the capital gains tax anymore. Two, you can take that entire amount. Deduct it against your corporation’s income. That could save you 50% tax or 27% tax. It depends whatever your corporate tax rate is. It saves you that tax on top of that, plus the whole amount of the capital gain, not just part of it. Now, its one-third goes to a CDA.
For a donation, the whole thing still goes to the capital dividend account. You can give that a very large capital dividend relative to a small one if you’re donating appreciated securities rather than just giving money. If you’re just to sell stuff or give cash instead, you’re not going to get all of those benefits. You’ll just get a deduction, and that’s it. On the personal side of the house, again, if you have appreciated securities, that has similar benefits without the capital dividend account part.
[01:00:45] Moderator: Wonderful. I really appreciate that you do mention charitable giving as something to do throughout the timeline as well. I guess another question, and maybe this would be the last question, is what is the role of using a family trust as a way for inheritance planning within a medical corporation?
[01:01:02] BF: What I will say is that one of the things that Mark and I were chatting about recently is using an estate freeze in planning for the long term for a corporation. A family trust can definitely play a role there when it’s all being set up, but it’s not an easy thing to just talk about off the cuff in terms of when a family trust may or may not make sense. They can play a role in planning with the corporation. I’d either need a super specific question or a lot of time, so it’s probably enough to just leave it there.
[01:01:28] MS: Yes. It’ll have to be a Money Scope episode.
[01:01:30] BF: That’s right.
[01:01:32] Moderator: I’m happy to have both of you joining this conference and doing a Money Scope Podcast. You covered a huge amount of topics. Thank you everyone for joining today’s session. In terms of the recordings, they will be up within the next couple of days, and you’ll get an email with a notice of the recordings being up. Once again, thank you, Mark and Ben, for closing this session and for all of the work that you have put into the Money Scope Podcast.
[01:02:03] MS: Thanks for having us.
[01:02:05] BF: Thanks for having us.
