IPP suitability scorecard – Business owners and professionals

Expanded retirement tax-sheltering using defined benefit pension rules

Registered Retirement Savings Plan (RRSP) contribution room is calculated based on a percentage of an employee’s annual income. Comparatively, a defined benefit registered pension plan (your own RPP) combines income with actuarial factors such as an individual’s age and the plan’s features to open the way toward significantly larger tax-deductible deposits.

Qualified business owners and incorporated professionals may establish a plan for one person, or up to three pension members – including spouse and family employees.

Check the boxes here to see if it is suitable for you:

❏ Is the business owned by and run through a corporation? Or if it is a professional practice, is it operated through a corporation?

❏ Does the owner draw annual income of at least $70,000 to $100,000, either as employment income alone, or combined with dividends?

❏ Is the business owner or professional at least 38 years of age, but no older than age 72?

❏ Has the owner maximized RRSP contributions, but is still seeking more CRA-approved tax-sheltering opportunities?

❏ Is there surplus corporate cash that is exposed to the punitive corporate tax rates on passive income?

If you have at least three checks so far, then this could be your route to expanded tax-sheltered savings, and here’s more to consider.

❏ Would it be appealing to increase the amount for annual spousal income splitting, and make it available before age 65?

❏ Are there any concerns that business creditors may get access to corporate assets meant to fund the owner’s retirement?

❏ Are there family employees for whom the owner would like to arrange a tax-deferred estate transfer, bypassing creditors and probate?

❏ Is there an anticipated or pending business sale where excess assets may threaten the owner’s claim to the lifetime capital gains exemption?

❏ If planning to retire abroad, would the owner like allow for greater tax-deferral by limiting emigration tax on deemed dispositions?

The ideal candidate for this kind of retirement pension will have at least six checks.

To learn more about how this can work for you, see the article IPPs – Individual pension plans.

IPPs – Individual pension plans

A business owner’s option for retirement savings

As a successful business owner, you likely maximize your annual registered retirement savings plan (RRSP) contributions and still have more to invest. So, is there is a way for you to make even more use of tax-sheltered retirement savings tools?

As it turns out, the Income Tax Act allows you, as the owner of a corporation, to set up an individual pension plan (IPP) for yourself as an employee of the business. By doing so, your corporation will be able to make larger tax-deductible contributions than available under RRSP rules, which in turn means larger deposits into retirement tax-sheltering for you as an employee.

Larger contributions with an IPP

Every worker is entitled to RRSP contribution room based on 18% of the previous year’s earned income. There is a dollar limit to that, which is indexed from year to year. The 2024 limit is $31,560, reached at 2023 income of $175,333. Any RRSP room not used in a year can be carried forward to make contributions in future years.

Unlike this direct calculation of RRSP contribution room, an IPP is a ‘defined benefit’ arrangement where the amount to be contributed is based on the benefit that will be required to be paid out of it. For both RRSPs and IPPs, investment growth is tax-sheltered while in the plan, with tax being deferred until payments come out to the annuitant/pensioner.

An actuarial calculation is required to make the IPP contribution determination, based on factors such as the employee/pensioner’s age, past employment income and projected future employment income, and the amount and terms of the eventual pension to be paid. Up until about the age of 40, RRSP rules provide more contribution room, but an IPP allows increasingly greater room as you move beyond that age.

Additional administration

An individual RRSP can be set up with fairly simple administration and low cost. An IPP has more complexity and higher cost, but for qualified candidates this is more than compensated by the added flexibility the IPP provides for retirement savings. As well, all fees involved in arranging an IPP are deductible to the employer corporation.

As a conscientious business owner, you will want to do a cost-benefit analysis with your investment advisor and tax professional. With larger start-up and periodic maintenance costs, an IPP will likely only come into consideration for those at higher income levels, generally at least $100,000. Still, sometimes it may be desirable to establish one while at a lower income level, in anticipation of moving up in income as the business builds.

A trustee must be appointed to manage the IPP under a formal pension agreement, and tax filings are more involved than for RRSPs. An actuarial report must be prepared when the IPP is established and triennially (every three years) thereafter, and provincial pension reporting may be required.

Provincial Developments

Pension rules protect pensioners from potential mismanagement of funds by employer-sponsors. Given the connection between pensioner and employer in an IPP, some provinces allow IPPs to opt out of pension rules, exempting the employer from mandatory contributions, and reducing reporting obligations and associated fees.

Provinces currently allowing opt-out are British Columbia, Alberta, Manitoba, Ontario and Quebec.

IPPs that have opted out of provincial oversight still employ actuarial rules to determine the maximum amount of contributions that may be made to a plan. All IPPs must be registered with the Canada Revenue Agency, and must fulfill annual tax reporting obligations.

Source and timing of contributions

On startup of the IPP, it is possible to fund past employment service as far back as 1991. The allowed amount is calculated by an actuary, then funded by:

1. Transferring-in existing RRSP holdings;
2. Making a deductible employee/personal contribution up to the amount of unused RRSP room; and,
3. Making a deductible employer contribution for the remainder.

Ongoing, annual employer contributions by your corporation are also deductible. There is no income inclusion or tax benefit reported by the employee in the year those employer contributions are made.

The triennial actuarial test may reveal at some point that more has accumulated in the plan than is necessary for it to meet its pension obligation, based on the continuing contribution schedule. This would usually be a result of investment returns exceeding earlier expectations. When there is such a surplus, the employer/corporation’s funding will be temporarily reduced or suspended until things are back in line.

On the other hand, if the triennial test indicates a shortfall then the employer/corporation may be required to make further contributions. This built-in top-up feature allows an IPP to be replenished if investments underperform expectations, something that is not available under RRSP rules.

Per the information in the callout box on the first page, for an IPP that has opted out of provincial pension oversight the employer is exempt from mandatory annual contributions. For such plans, unused contribution room in a year may be carried forward to be used in future years at the discretion of the IPP trustee.

For all IPPs, the employer may be able to make a final deductible contribution before the pension begins if the actual conditions at that time differ from the assumptions used to fund the plan. This is called terminal funding.

Allowable investments

An IPP can usually 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 normally apply to pooled investments like mutual funds, which themselves hold a basket of securities.

Pension payout time

There are three options on retirement:

1. Take the pension pursuant to the terms in the pension agreement;
2. Use the accumulated value in the IPP to purchase an annuity from an insurance company; or,
3. Commute the value to make a tax-free transfer into a locked-in retirement income fund. Often the commuted value will exceed the tax-free transfer limit, owing to the generous IPP contribution rules. The excess is taxable, but there are no restrictions on the pensioner’s use of the net amount after the tax is paid.

As a final point, IPPs may be entitled to greater creditor protection compared to RRSPs, though this may not be the case if the IPP has opted out of provincial pension supervision. This may be an important issue for an entrepreneur looking to balance business and personal financial risk.

US pension transfer to a Canadian RRSP?

The if, when, what & how of repatriating retirement savings

We Canadians share much with our southern neighbour, well beyond the world’s longest undefended border. Many of us have stints or entire careers in the United States, then return home to Canada.

However, pension savings don’t automatically come back with us. While that money could remain tax-sheltered there, then drawn and taxed in our later years, it could simplify things if those savings could come back home too.

The process to make this happen is a bit complicated, but manageable with good preparation. Mechanics aside, the most important issue to understand is the taxation – and potential double-taxation – that may result if you’re not careful .

What plans qualify?

Generally, the kind of US plans we’re talking about are:

- 401(K) plans – The contributing employer-sponsor is a private sector for-profit enterprise
- 403(B) plans – For government employees, and those in religious, education and non-profit sectors
- IRAs – Individual retirement accounts, which are self-contributory plans similar to our RRSP

Plans from other countries may also qualify, but US plans are seen most frequently, again given the close proximity and economic ties between our two countries. Notably, if the foreign pension benefit is exempt from Canadian tax then these rules can’t be used.

You can’t transfer directly to your RRSP

From your personal view, you expect it all to remain tax-sheltered, so why shouldn’t you be able to make a direct transfer to your RRSP? Well, apart from maintaining the sovereignty and privacy of our tax system, there could be conflicting definitions, timing mismatches, and of course currency/exchange rates.

Instead, our system makes an allowance within our domestic tax rules once the foreign pension has been cashed-out. As this collapse of the foreign pension is almost certainly irreversible, you will want to be sure that the particular plan and transactions qualify under these rules; what gross and net-of-tax amounts are involved; and whether the actions can be completed in the available time frame.

Foreign withholding tax on cashing-out

The pension administrator will be required to withhold taxes, which is normally your final tax duty to the United States as the source jurisdiction. The general US withholding rate on a lump sum distribution from a retirement plan to a non-resident is 30%.

Comparatively, the Canada-US tax treaty allows for a reduced withholding rate of 15% on periodic payments from a retirement plan. In some cases, a pension plan administrator may take the position that the particular transaction qualifies for the reduced rate. This should be confirmed with the administrator, as well as with a US tax advisor whether you may nonetheless be responsible to the US for the higher rate, despite that a lesser amount may have been withheld at source.

Some pension administrators may (incorrectly) use the 20% withholding rate that applies on some domestic US transfers.

If you are under age 59.5, an additional 10% penalty tax applies to the withdrawal. Some administrators withhold this amount, but if not then you may need to file a US return to pay it yourself. In the past, the Canada Revenue Agency had not allowed a credit for that age-related penalty (more below on claiming credits), however it reversed its position a few years ago. It would be advisable to verify with the CRA on its current practice before proceeding.

Whether it’s 15%, 20%, 25%, 30% or 40%, the net amount to you will be in US dollars. Be sure to confirm with the plan administrator and a US tax advisor as to which of these apply and how they are handled. Apart from clarifying your US reporting obligations, this will help you determine how much cash you will need to come up with to meet your Canadian tax obligations, as we turn to that part of the process.

Canadian income tax inclusion

As a Canadian resident, you are taxable on your worldwide income. The gross amount received from the US pension – converted into Canadian dollars – must therefore be added to your other income in the year of de-registration and reported on your Canadian tax return.

Special RRSP contribution and deduction

A special RRSP deduction is available if the plan meets the Canadian definition of superannuation, pension benefit or foreign retirement arrangement. This is generally true for a 401(K), 403(B) or a regular IRA. (Different rules apply to a Roth IRA, which is similar to our tax-free savings account.)

Key to this special deduction is that the withdrawal must be a lump sum and specifically not be part of a series of periodic payments. Note that if the US plan administrator applied the reduced 15% withholding rate (that normally is used for periodic payments), the withdrawal should still qualify for the special deduction if it meets the lump sum definition under Canadian rules. Ask your Canadian tax advisor.

This special deduction does not require or affect existing RRSP contribution room. But unlike regular RRSP room, the special deduction can only be used in the same taxation year as the income inclusion or within the first 60 days of the following year. Any unused room cannot be carried forward.

Bear in mind that the plan administrator withheld tax before paying the net amount to you. To take advantage of the full deduction, you will have to top-up the contribution from another money source. On the other hand, if the amount is not topped-up then Canadian tax will still be due, based on the difference between the gross payout and the lesser amount of your contribution, in which case you will still need to come up cash to cover that tax.

Claiming the foreign tax credit

Once your preliminary Canadian tax for the year is calculated, the next step is to determine whether a foreign tax credit may be claimed for the amount withheld in the US. A key consideration is that if you have a large pension withdrawal but have relatively little income in the year, you may not be able to use the full credit, which cannot be carried forward. This opens up the possibility of double taxation on some part of the withdrawn pension: first in the year of withdrawal from the foreign pension, and then a second time on drawdown of the RRSP/RRIF.

Once more, it is critical to obtain advance tax advice on issues and estimates on both sides of the border.

Your retirement plans

Obviously, your decision will be affected by where you expect to retire, especially if you may end up back in the United States. And if you are a US citizen, there are additional considerations, even if you remain here in Canada. Be aware that the special contribution can only go to your RRSP, not to a RRIF, so this procedure must be completed no later than the end of the year you turn 71. As you can’t be certain how long it may take for that foreign plan administrator to process things, it would be prudent not to push it too close to that deadline.