You’ve just finished your residency and have finally started practicing medicine. Congratulations!
If you’re like most people finishing med school, you have a pile of student debt, which is weighing on your mind. You’re probably also getting lots of advice from colleagues, family, friends and financial planners.
Your first instinct might be to pay it down as fast as possible. Let’s call this the traditional approach. It’s a good strategy, but it might not be the best plan.
Another strategy is to set up a medical professional corporation that will enable you to leave money in the corporation and pay taxes at a lower rate and invest the savings. Let’s call this the combined approach.
In order to explore the difference between these two approaches to paying off your medical school debt, let’s start with certain assumptions based on common scenarios that we often see.
- Debt is at $100,000 and interest is being accrued at 3%
- Annual income from medical services is $200,000
- Your spouse contributes $25,000 to the household income
- Your annual family budget for personal expenses, mortgage, travel, clothing etc. is $80,000
- You have elected to be remunerated using a growingly popular dividends only option (using 2013 tax rates)
- Investments are assumed to be earning 6% per annum tax effected down to 3%.
The Traditional Approach
The traditional approach involves putting your head down, working really hard and paying off your debt as fast as possible. With this option, you would only incorporate once your debt is paid off. The debt would be fully repaid during the middle of year two. By the end of year three, there would be $176,854 in your corporation’s investment account.
In this scenario you would earn all of your income via self employment in the first year. Once you have paid your personal expenses and personal taxes you would be able to put $68,658 towards your debt, but there would be no money left to invest. In year two, you would spend part of the year self-employed, pay off the remainder of the debt and then you would incorporate in the middle of the year. The rest of the year you would be paid via dividends of $13,654 from your corporation. In year three you would earn the full income within the corporation and pay yourself dividends in the amount of $59,000. The remaining funds would remain in the corporation to be invested.
The Combined Approach
The second option is called the combined approach. This option involves setting up a medical corporation early and paying yourself enough dividends to cover your personal expenses. Additional dividends are paid out (to be used for debt repayment), only until you reach the top marginal tax rate. The reason for doing so is that once you go over that top marginal tax rate you would pay more in tax than you would in interest on your loan.
The debt in this scenario is repaid by the end of the third year rather than the second year. However, at the end of year three you have $203,685 within your corporate investment account.
In this scenario you would pay yourself annual dividends right from the start – $105,000 in years one and two and $102,000 in year three. After paying personal taxes and personal expenses, the rest of the money would go towards paying off personal debt.
The total difference yields a tax savings/deferral of $26,831 over 3 years. In order to be accurate, we must also factor in the additional corporate accounting costs you would incur by incorporating one year sooner. These fees run between $2,000 and $3,000, so the total benefit would actually be $23,831- $24,831. This approach works for many situations and in certain circumstances the benefits can be much larger. For example, if your spouse is earning lower or no income, you can income split through the corporation to further increase the tax savings.
If you think this approach might work for you, be sure to speak with a qualified accountant or tax practitioner to find out what steps you’ll need to take.
By Larry Hasson CPA, CA
McIntyre & AssociatesProfessional Corporation
200 – 900 Morrison Drive
200 – 900 Morrison Drive