A physician we'll call Dr. Barbara, 33, has a thriving practice in Ontario. Gross income from her practice, about $375,000 to $400,000 per year, is channelled through her professional corporation, and she draws a small salary from it. Her financial affairs, like those of many doctors, are not well organized.
There are four sets of issues facing Dr. Barbara: First, on a salary basis, she is drowning in red ink. In reality, she is strongly cash-flow positive, but reorganization of her income is required. Second, she is allowing money to build up within her company without managing it. An investment strategy is required. Third, she needs to set up a retirement plan. And fourth, she has to come to terms with the inevitability of her own mortality and prepare a structure for transmission of the wealth that she is building.
We asked Derek Moran, a financial planner who heads Smarter Financial Planning Ltd. in Kelowna, B.C. to work with Dr. Barbara
"This is a case of an immensely talented professional who is failing to make the most of her financial success," Mr. Moran says. "What we have to do is to show how, with a few adjustments, she can have the disposable income, security and wealth that her many years of training deserve."
She draws a salary of $30,000 a year from her corporation, a sum insufficient even to pay her home mortgage cost of $3,200 per month. She estimates that she allocates a further $3,000 per month to such personal expenses as food, clothes, gas for her car, utilities, decor for her house, etc. Theoretically, she is utterly broke at the end of each month. To cover the gap, she has had her medical corporation pay dividends to cover expenses. It is a questionable strategy.
As an employee of her corporation, she pays payroll taxes such as Canada Pension Plan (CPP). That costs her a full 9.9% of salary, half payable from her pay cheque and half by her employer, which is herself. She could, in theory, skip that by choosing to pay the small business corporate tax rate in Ontario, reduced in 2009 to 17%, and then pay out the after-tax residue of corporate income as dividends. In effect, this is what she has been doing.
The problem with paying out income as dividends is that it does not create space for Registered Retirement Savings Plan (RRSP) contributions. Currently, the limit is the lesser of 18% of earned income or $21,000 for 2009. The $30,000 salary she receives generates only $5,400 of RRSP contribution space.
She should increase her salary to maximize RRSP contribution room. This year, her salary should be $116,667, Mr. Moran figures. The balance of income earned by her corporation should be left alone, unless she elects to increase payouts in either dividends or wages to accelerate payments on her $365,000 home mortgage, the planner adds.
In the end, the question of whether to pay salary or dividends is philosophical as much as it financial. The dividend route, combined with the lower small business tax, preserves income in the short run. In the long run, the salary route adds to CPP, which is an indexed, government-guaranteed pension. More RRSP space is a good thing too, providing tax efficiencies in Dr. Barbara's high bracket. Therefore, taking $116,667 per year in salary and leaving the balance of revenue from her practice for dividends is a blended approach, the planner notes.
Planning for her departure from her medical practice takes both self-assessment and some pencil work. She wants to retire at age 50 or 55, an age she has targeted so that she will not be, as she puts it, "one of those doctors who has to keep working beyond age 65 for lack of a retirement plan."
Assuming that Dr. Barbara lives to age 90 and retires at age 50, she will need sufficient capital to fund 40 years of living. If she needs $10,000 per month before tax, or $120,000 per year, and if she can achieve a 3% average annual return on her savings, she will need retirement capital at age 50 of $2,856,986.
She will be eligible for Old Age Security (OAS) benefits, currently $6,204 per year, but given her income those benefits would likely be lost to the OAS clawback, which starts at $65,335. The limit is adjusted annually for inflation.
If Dr. Barbara elects to increase her salary and maximize CPP contributions, she would be able to draw 65% of the current maximum benefit of $10,905 per year, or $7,088 per year at age 65. The CPP draw would reduce her savings requirement to $2,744,000, Mr. Moran says.
To reach the capital required, she would have to save $11,400 if she chooses the dividend route of tax minimization, or $11,000 per month if she chooses to maximize her RRSP room. Best bet? Maximize RRSP space first, and then keep retained earnings in the professional corporation. It should be noted that her present $31,875 monthly gross practice revenue, even allowing for taxes, enables the plan to work.
Dr. Barbara's present net worth, $678,000, will grow dramatically over the next two decades. She anticipates helping her parents financially now and in future, but there are risks. If she were to become disabled or to die prematurely, her parents could suffer financially.
She has substantial and adequate disability coverage. However, Dr. Barbara does not like the concept of life insurance. Her hospital forces her to take out a minimum of $265,000 in term coverage. Otherwise, she insists, she would have none. The idea of betting on your own death is alien to many people. But life insurance has many other virtues. Among them, it is an asset in the case of whole life or a contingent asset in the case of term life. Either way, life insurance value is not dependent on the ups and downs of capital markets -- core coverage is determined mainly by estimates of mortality. Once in place, whole or ordinary life insurance guarantees money for retirement or for death benefits for named beneficiaries. Life insurance also provides substantial protection of assets from claims of creditors.
Dr. Barbara's parents, now in their early 60s, can be taken care of with an insurance policy on her life or via designation of her estate to the parents. If the estate, including a life insurance payment following her death, were $800,000 after all costs, and spent over a 27-year period while generating a 3% return, it would provide an income of $42,380 a year before tax, Mr. Moran estimates.
"If this physician can make some sensible financial choices, she will have wealth and security," the planner concludes.
Doctor with substantial income needs to manage taxes, investments, retirement
Increase income to maximize RRSP space, hire investment manager, plan estate
Lower taxes and more security for dependent parents
MONTHLY AFTER-TAX INCOME $6,000
with possibilities for increases and dividends
House $800,000RRSP $55,000
Cash in corporation $65,000
Parents' mortgage $113,000
Property tax $494
Phone, cable, Internet $200
Car maintenance & gas $140
House decor $550
Gifts, charity $150