If you incorporated your medical practice, you probably did so in order to reduce taxes and save more than you could with registered retirement savings plans (RRSPs) and tax-free savings accounts alone.
Many incorporated physicians use a combination of options to save for retirement. So the question is how best to allocate your funds, and what portion to invest through your corporation.
One major consideration is whether you will be impacted by the new passive income rules, which took effect January 1, 2019. We will outline how this increases the relative value of RRSPs.
Let’s review the basics
Your practice income is earned by your corporation. You decide how best to compensate yourself, with either salary or dividends. The net practice income (after deducting any salary) earned by the corporation is taxed at the low small business tax rate, rather than your personal tax rate.
By being incorporated, you can cut annual taxes by as much as 75% on up to $500,000 of your practice income (the limit for the small business tax rate). The money you save on taxes can be invested through your corporation. Any earnings from that investment—interest, dividends, capital gains—are called passive income.
Although earning income on investments is usually welcomed, it’s important to remember that passive income in a corporation is taxed at higher rates than your practice income. What’s more, as of 2019, passive income can now limit your access to the low tax rate on your practice income.
Here’s a formula to calculate how much passive income you can have before your access to the small business tax rate is reduced:
For example, if your corporation has $350,000 of practice income (before paying you—more on that below), passive income must stay below $80,000 ($150,000 – [$350,000 / 5]) to avoid a higher tax rate on your practice income.
How RRSPs help mitigate the passive income rules
If you are affected by the new passive income limits, paying yourself salary and contributing to your RRSP can help mitigate the impact.
Let’s look at how this works. A salary (unlike dividends) creates RRSP contribution room for you. You can then use your RRSP as a savings vehicle—one where the investments grow tax-deferred until it’s time to withdraw. This way, the portion of your investments that create passive income goes down, while your total investments remain the same or even go up.
What’s more, you can contribute to a spousal RRSP, which is a great way to split income with a lower-income spouse and further reduce taxes.
Another benefit of paying yourself a salary is it reduces the corporation’s net practice income. Let’s return to the passive income formula and our example above: if you paid yourself a $150,000 salary, the corporation’s net practice income would be reduced to $200,000 (from $350,000 above).
This would increase your passive income threshold to $110,000 ($150,000 – [$200,000 / 5]). In other words, you could have up to $110,000 in passive income and still be entitled to the small business tax rate on your $200,000 in practice income.
So, if you are already contributing to RRSPs, continuing to do so is probably the right thing to do. If you aren’t, it may be worth re-evaluating your strategies.
Your accountant is in the best position to advise you on how much salary you should take from your practice income. Your MD Advisor can help you determine how to manage your corporation’s passive income and strike the right balance between corporate investments and RRSPs.
If you have any questions about the effect of the passive income rules on your current financial plan, please contact your MD Advisor.