While some people struggle to find the money to contribute to a registered retirement savings plan (RRSP), successful entrepreneurs regularly maximize their allotted room and look to their financial advisors for more – and more effective – avenues for savings.
A specific subset of income tax rules allows a business owner who is an employee of his or her own corporation to establish an individual pension plan (IPP). This is a defined benefit pension plan with up to three members where at least one of them is related to the employer. Thus, the business owner’s corporation will not only enable such operational benefits as isolating liability and accessing favourable small business tax rates, but also open the potential for larger deposits, deductions, accumulation and payouts for personal retirement savings.
Funding basis
The basic principle in funding an RRSP is that the amount that can be deposited into the plan is dictated by one’s current (or rather recent) income. Subject to the annually indexed dollar maximum, each person is entitled to annual room equal to 18% of the previous year’s earned income.
By contrast, an actuarial calculation is required to determine the amount an employer can and must contribute to an IPP. This calculation is based on a variety of factors, including the particular individual’s age, past and projected future employment income, and the amount and terms of the pension the employer will be required to pay. If the individual is 40 or older, allowable contributions into an IPP will generally be larger than under the RRSP formula.
Registration requirements
Whereas an individual RRSP can be established with relatively simple administration and low cost, an IPP is more complex and has attendant costs. The plan assets must be managed by a trustee who has regulatory and tax-filing requirements. As well, an actuarial report is required at the outset and every three years thereafter.
In addition to plan administration services, the plan must pay for the cost of the initial and periodic actuarial reports. These costs will depend on negotiations with service providers, and should be balanced against the tax and other benefits sought to be achieved by establishing the IPP.
Due to the start-up and maintenance costs, an IPP usually comes into consideration only once employment income approaches the top federal tax bracket.
Contributions
The IPP is a legally binding agreement between the corporation, as employer, and the individual, as employee.
On creation, it is possible to fund the employee’s past service to the employer (as far back as 1991) through an initial lump-sum contribution. In the past, this could have been carried out as a large immediate contribution and deduction from the corporation/employer alone. As a result of changes introduced in the 2011 Federal Budget, the past service contribution must now first be satisfied through the transfer of the individual’s existing RRSP assets and unused RRSP contribution room.
Ongoing, annual contributions will entitle the corporation/employer to a tax deduction. As with RRSP contributions, there are no immediate income tax consequences to the employee at this time.
As mentioned, the plan must be actuarially tested every three years to determine whether the invested assets are sufficient to fund the plan’s pension obligations. Where it is determined that the funding is insufficient, the employer may be required to make further contributions to make up the shortfall. On the other hand, where the value exceeds the pension obligations, the employer may be required to take a temporary break from making contributions.
Allowable investments
An IPP can essentially invest in the same types of investments allowed for RRSPs. The rules are a little more restrictive, however, in that no more than 10% of the assets may be in any one security. This restriction does not apply to mutual funds, which themselves are diversified holdings.
Rights to pension income
There are three options on retirement. First, the value of the IPP may begin paying the required pension. Depending on the terms of the plan, any remaining value at death may be payable to the estate or a beneficiary, or remain for the benefit of surviving IPP members. Changes introduced in the 2011 Federal Budget subject this pension to mandatory withdrawals after age 71, similar to the treatment of a registered retirement income fund.
Second, the IPP value may be used to purchase an annuity from an insurance company.
The third option is for the IPP to be commuted and transferred to a locked-in registered plan as allowed by the governing provincial or federal pension administration rules. In this case, if the accrued pension benefits exceed the allowable transfer limit under the Income Tax Act (Canada), the excess amount will be taxable.
As a final point, creditor protection has a part to play in the decision whether to use an IPP and when or how to draw it down. Depending on the province, a higher degree of creditor protection may be accorded to an IPP over an RRSP, which may be a key issue to an entrepreneur looking to balance business and personal financial risk.