4% rule / 25x expenses for incorporated physicians?

[Hanmari]

Lots of rambling questions below, apologies in advance for the poor read.

The general rule as per Trinity study is 4% safe withdrawal rate (SWR) for retirement, or 25x annual expenses in your portfolio. I know there's a lot of more conservative talk about 3/3.5% SWR these days but I understand the 4% as a general guideline that's tried and tested.

But I have a hard time understanding how this plays out with incorporation because the number you see in your corporation is larger than what you would have if you paid it out to yourself as actual cold hard cash, given the taxation deferral. Is it as simple as calculating the difference in corporate/individual tax rates and applying it to the amount held in corp? Or are there other details to consider when thinking of your corp as an asset? For example, does it matter how much you decide to draw as salary vs. dividends in retirement, given they are taxed differently and one is eligible for RRSP room and not the other? Or does tax integration make that irrelevant?

I am mindful of not letting the tax tail wag the investment dog but I am wondering if all these differences in the end amount to a significant deviation from the 4% rule in terms of the number that should be aimed for in corporation.

I know also I will probably have all the intricacies explained to me once I go see an advisor/accountant when I'm a grownup, but I got curious and was wondering if there is some sort of general guideline number a la the 4% SWR. If such a thing exists it would put me more at ease about roughly how long I should expect to work until FI. Thanks!

[rice]

I'm sorry to add on to your list of excellent questions, but also as a side note, can someone please explain why exactly the tax deferral of the corp is beneficial? Whether you get taxed now or in retirement on withdrawal, isn't the final value the same? Is it because you expect to be taxed at a lower income bracket in retirement?

This is something I've never been truly able to wrap my head around.

[JohnGrisham]

15 minutes ago, rice said:

I'm sorry to add on to your list of excellent questions, but also as a side note, can someone please explain why exactly the tax deferral of the corp is beneficial? Whether you get taxed now or in retirement on withdrawal, isn't the final value the same? Is it because you expect to be taxed at a lower income bracket in retirement?

This is something I've never been truly able to wrap my head around.

Generally, yes. You pull money out, when you are no longer working and don't have a personal income or it is much lower. Whatever you take out of the corporation, will be taxed at your personal bracket etc.  

Theres other nuances to the corporation of course - but despite the kool-aid, it is not always the best decision for everyone. People just assume that having a corp (with extra added costs/accounting) will always* be beneficial, but then end up doing things wrong* and actually are worse off(minorly) than had they not incorporated.

[rmorelan]

4 minutes ago, rice said:

I'm sorry to add on to your list of excellent questions, but also as a side note, can someone please explain why exactly the tax deferral of the corp is beneficial? Whether you get taxed now or in retirement on withdrawal, isn't the final value the same? Is it because you expect to be taxed at a lower income bracket in retirement?

This is something I've never been truly able to wrap my head around.

There are a bunch of reasons - mostly boils down to both the somewhat lower overall average tax rate later on, and also the fact that money not taken now has an opportunity to compound. 

For most people you would be in a lower tax bracket (unless you saved so much you ended up with greater income in retirement than while working). If you did that there is a strong argument you saved too much actually. 

 

[rmorelan]

4 minutes ago, JohnGrisham said:

Generally, yes. You pull money out, when you are no longer working and don't have a personal income or it is much lower. Whatever you take out of the corporation, will be taxed at your personal bracket etc.  

Theres other nuances to the corporation of course - but despite the kool-aid, it is not always the best decision for everyone. People just assume that having a corp (with extra added costs/accounting) will always* be beneficial, but then end up doing things wrong* and actually are worse off(minorly) than had they not incorporated.

Nope definitely isn't the best for everyone - and it can be used incorrectly. Part of making sure your overall financial plan works is getting educated about them  

 

[rice]

1 minute ago, rmorelan said:

There are a bunch of reasons - mostly boils down to both the somewhat lower overall average tax rate later on, and also the fact that money not taken now has an opportunity to compound. 

For most people you would be in a lower tax bracket (unless you saved so much you ended up with greater income in retirement than while working). If you did that there is a strong argument you saved too much actually. 

 

The lower tax argument makes total sense, but the bolded statement is something I've heard before too and is what I have difficulty understanding. Assuming that I was withdrawing in retirement the same income that I earn during my career (i.e. no tax bracket differences), shouldn't the fact that it is compounding pre-tax or post-tax be irrelevant mathematically?

[rmorelan]

1 hour ago, Hanmari said:

Lots of rambling questions below, apologies in advance for the poor read.

The general rule as per Trinity study is 4% safe withdrawal rate (SWR) for retirement, or 25x annual expenses in your portfolio. I know there's a lot of more conservative talk about 3/3.5% SWR these days but I understand the 4% as a general guideline that's tried and tested.

But I have a hard time understanding how this plays out with incorporation because the number you see in your corporation is larger than what you would have if you paid it out to yourself as actual cold hard cash, given the taxation deferral. Is it as simple as calculating the difference in corporate/individual tax rates and applying it to the amount held in corp? Or are there other details to consider when thinking of your corp as an asset? For example, does it matter how much you decide to draw as salary vs. dividends in retirement, given they are taxed differently and one is eligible for RRSP room and not the other? Or does tax integration make that irrelevant?

I am mindful of not letting the tax tail wag the investment dog but I am wondering if all these differences in the end amount to a significant deviation from the 4% rule in terms of the number that should be aimed for in corporation.

I know also I will probably have all the intricacies explained to me once I go see an advisor/accountant when I'm a grownup, but I got curious and was wondering if there is some sort of general guideline number a la the 4% SWR. If such a thing exists it would put me more at ease about roughly how long I should expect to work until FI. Thanks!

The 4% rule is the general rule (but like you said know the assumptions - for one thing it is based on 30 years of retirement so all those retire early people need to be aware of it - the math breaks down in longer time periods). I will say that I find the assumptions that go into it a bit silly - for instance it assumes you don't EVER change your spending regardless of what is happening with your investments. If you are retired, probably own your home along with all the rest of your stuff you are probably in the best position to change your spending if needed. If it the 30 year old with the full mortgage and a young family and debit obligations that is really locked in. If you have a long horizon ahead of you, and your investments in the beginning go down a lot I would say you should adjust rather than blindly taking out 4% etc - if you can do that then the 4% becomes even more safe basically. 

obviously any salary vs dividend rules for applying in the distant future is harder to predict. Tax integration rules will in general make them exactly the same - although a rule of thumb is withdraw enough salary to max out your RRSP room, and then go dividends. There is some simply math you have to do each year to optimize a bit but it isn't hard. 

and all that doesn't impact the 4% rule at all - do the math basically pretty much similarly. It can be more complex once you hit certain ceilings for passive investments but even then it is more in your favour.

[rmorelan]

6 minutes ago, rice said:

The lower tax argument makes total sense, but the bolded statement is something I've heard before too and is what I have difficulty understanding. Assuming that I was withdrawing in retirement the same income that I earn during my career (i.e. no tax bracket differences), shouldn't the fact that it is compounding pre-tax or post-tax be irrelevant mathematically?

yeah that is similar to the RRSP vs TFSA arguments - they are both exactly the same in after tax amounts even though they are taxed at opposite stages of the spectrum (TFSA now, RRSP later). that is true.

But in those cases the returns from each year are not taxed, because they are both in a tax shielded state on a year to year basis. However the money you would take out from the corp is not shielded anymore (and far too much to put in your combined TFSA and RRSP (which many say you should make out). Now you are stuck paying yearly tax on the return of the investment - which blunts compounding. 

Take an example - assume you are always in the 50% tax bracket, and you invest in bonds. To make the math simply assume 100% tax deferral in the corp. You would lose immediate 50% of the money due to tax so you start with 10K in the corp, and 5K in your personal investments. Lets also assume 10% return, and it is all interest on those bonds so the government is going to want 50% of that interest if outside of the corp. All those assumptions are just to really highlight the difference, but of course the real effect is less as the crop is not 100% deferred (there is a business tax), and you have capital gains/dividend tax protections on may investments - I don't think that really hides the point though and you are probably going to own at least some bonds so for that portion it directly applies. 

Effectively due to the yearly taxation you end up with a return of 10% in the corp, and only 5% in your persona savings on your investment- every year the government wants its 50% of the interest. Rolling it out over 20 years:

	Deferred		Taxed
1	$ 10,000.00		$ 5,000.00
2	$ 11,000.00		$ 5,250.00
3	$ 12,100.00		$ 5,512.50
4	$ 13,310.00		$ 5,788.13
5	$ 14,641.00		$ 6,077.53
6	$ 16,105.10		$ 6,381.41
7	$ 17,715.61		$ 6,700.48
8	$ 19,487.17		$ 7,035.50
9	$ 21,435.89		$ 7,387.28
10	$ 23,579.48		$ 7,756.64
11	$ 25,937.42		$ 8,144.47
12	$ 28,531.17		$ 8,551.70
13	$ 31,384.28		$ 8,979.28
14	$ 34,522.71		$ 9,428.25
15	$ 37,974.98		$ 9,899.66
16	$ 41,772.48		$ 10,394.64
17	$ 45,949.73		$ 10,914.37
18	$ 50,544.70		$ 11,460.09
19	$ 55,599.17	Final	$ 12,033.10	Final
20	$ 61,159.09	$ 30,579.55	$ 12,634.75	$ 12,634.75

 in the very last step I took all the money out of the crop and paid 50% on it when I did - gives me roughly 30K. The non sheltered personal investments - only roughly 13K. Now that is not a small difference (although of course 10% bond return ha would be hard to get - at lower interest rates the effect is also less). 

 

[rice]

That makes much more sense. Lots of variables to think about. 

 

[rmorelan]

5 minutes ago, rice said:

That makes much more sense. Lots of variables to think about. 

 

Ha true - but really once you go through it then you are in a good place, and it isn't hard really. There are also a ton of resources to help down the line. A little bit of education sets you up success. 

and all those premeds - I wouldn't really worry about any of this yet of course. Really the point of talking about it at all is two fold - one making sure you get what you earn in the end makes happier less burnout doctors, and that is something I personally think is important. Two people should have a full sense of the rewards of any career they are pursuing.   

[Hanmari]

Thanks both for the replies and the discussion!

It's that 30k vs. 13k difference from Rmorelan's table I am wondering about, more or less. I know that is hypothetical and irl we would not have the same numbers / we would not be taking out all our corp money in lump sum, but there is basically some sort of tangible difference between corp money and personal money that is difficult to calculate. I would love to be able to look at my corp as staff and know oh, this is how much money I actually have, were I to retire that day and start drawing down from it.

[rmorelan]

58 minutes ago, Hanmari said:

Thanks both for the replies and the discussion!

It's that 30k vs. 13k difference from Rmorelan's table I am wondering about, more or less. I know that is hypothetical and irl we would not have the same numbers / we would not be taking out all our corp money in lump sum, but there is basically some sort of tangible difference between corp money and personal money that is difficult to calculate. I would love to be able to look at my corp as staff and know oh, this is how much money I actually have, were I to retire that day and start drawing down from it.

I think it may be easier to think of it as an upper bound 

Since the you won't take it all out at once, the tax rate at withdraw is very likely lower than during peak working years. 

Since not all the money is a corp is effectively tax shelter as passive income rises (usually at least) the math actually become less complex after a point

I would put it this way - if you had 1 million in the corp then you could if you believe in the 4% rule take out 40K indexed for inflation like everyone else. The fact that the core principle in the corp hasn't been taxed yet won't matter as you are effectively not taking that money out (ideally ever - under the 4% rule under many scenarios you end up with MORE money at the end of the 30 years considering inflation so your principle is never actually touched. The rule is highly conservative). You can plan based on that relatively easily, and the minor differences otherwise kind of work out in your favour for the most part. In all my math calculations I am basically doing exactly that.