Tag: Registered 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 persons holding Canadian registered plans

The challenge of two-fold tax compliance

Both Canada and the United States levy income tax on their residents. The US also taxes its citizens and ‘green card’ permanent residents (collectively “US persons”) wherever they are in the world.

Though our two systems are generally coordinated to avoid double-taxation, the US treatment of Canadian registered plans varies. The US taxes some income that is tax-sheltered in Canada, and has reporting rules that can make it more costly and complicated for US persons to hold such plans.

Retirement savings – RRSP, RRIF

Contributions

A Canadian Registered Retirement Savings Plan (RRSP) is like a US 401(K), the main US workplace retirement plan. The number refers to the relevant section of the US tax code. Despite the similarity, US domestic rules don’t allow a deduction for RRSP contributions, though the later withdrawal of those amounts are not taxable.

However, a deduction may be possible through an exception in the Canada-US Treaty (the “Treaty”) for qualifying retirement plans (QRPs). This is directed at plans that are primarily employer-sponsored, so not all RRSPs qualify as QRPs, though group RRSPs likely do. The deduction is limited to the current year’s maximum 401(K) limit, which is $US23,000 for 2024, and may be higher for those over age 50.

Note that 401(K) room is a per-year allotment, unlike Canadian RRSP rules that allow unused room to be carried forward to future years. Bear this in mind when considering a large single year RRSP catch-up contribution. It may be necessary to spread that contribution over multiple years to assure deductibility in both countries.

Growth

Income in an RRSP or Registered Retirement Income Fund (RRIF) is taxable in the year earned under US domestic law. Fortunately the Treaty has an exception that allows a deferral of that taxation until withdrawal. Prior to 2014, the RRSP/RRIF holder had to file Form 8891 to obtain the deferral, but it is now automatic.

Withdrawals

As noted above, undeducted RRSP contributions may be withdrawn tax-free for US purposes. Otherwise, both Canada and the US tax RRSP and RRIF withdrawals in the year taken. When filing the US tax return, a foreign tax credit can be claimed for the Canadian tax paid. Be aware that the Canadian pension income splitting rules (allowing a portion of certain RRIF payments to be allocated and taxed to a recipient’s spouse) have no effect on US reporting, where each person reports the income he or she actually received.

Non-retirement savings – TFSA

The Canadian tax-free savings account (TFSA) was legislated in 2008. Contributions are not tax-deductible, growth is tax-sheltered, and withdrawals are not taxable.

There is no special status for TFSAs under US domestic law, nor is there any relief under the Treaty, which was amended by the Fifth Protocol in 2007, just prior to the TFSA’s introduction. While the US makes no reference to TFSAs, the tax community consensus is that they are likely to be treated as foreign trusts, requiring an annual report of transactions and ownership information, using Forms 3520 and 3520-A respectively.

Details will also have to be reported at the same time as the US person’s income tax return using Form 8938 “Statement of Specified Foreign Financial Assets”, and for banking secrecy disclosure to the US Treasury on FinCEN Form 114, known as the “Report of Foreign Bank and Financial Accounts (FBAR)”.

Education savings – RESP

The Canadian Registered Education Savings Plan (RESP) provides tax assistance for education savings. Most commonly, parents or grandparents are the plan subscribers, saving for a child’s education. Contributions are made from after-tax money, with potential assistance from government sources. Income is tax-deferred when in the plan, and generally taxed to the student when withdrawn for education purposes.

A Canadian RESP is not tax-exempt under US domestic rules, and instead is likely to be treated as a foreign trust. Until recently, this required the annual filing of Forms 3520 and 3520-A as outlined above under TFSAs; but in March 2020, the US announced an exception for non-US plans for “medical, disability, or educational benefits”. There is however no relief from Form 8938 and FBAR filing, and the tax treatment remains unchanged.

That being so, a U.S person subscriber will be taxed on income generated in the plan. In addition, government grant money is likely to be treated as income for that subscriber in the year it is paid into the plan. Double-taxation can arise later when a student-beneficiary is taxed in Canada on education assistance payments.

If the student-beneficiary is a US person, RESP distributions will be taxed each year paid, unless proof is shown that the amounts are not taxable (for example, if they are partly or fully return of capital). Historically, a US person beneficiary would have to file Form 3520 in the year of any distributions. A US tax professional can advise whether the March 2020 exception relieves this requirement.

Disability needs – RDSPs

The Canadian Registered Disability Savings Plan (RDSP) provides tax assistance for those with a qualifying disability. Parents or other close family members may open a plan for a minor-age child beneficiary with a disability. The child may become the holder at age of majority if he or she is contractually competent.

Contributions are made from after-tax money, with significant assistance from government sources. Income is
tax-deferred when in the plan, and taxed to the beneficiary when withdrawn later in life.

Like RESPs, US tax concerns arise with RDSPs if the beneficiary (or a holder on behalf of the beneficiary) is a US person. These include the treatment as a foreign trust (along with the relief from Form 3520 and 3520-A filing), continuing Form 8938 and FBAR filing obligations, and similar concerns about double-taxation. Once again, a US tax professional can advise on these matters.

Summary

This article provides an overview to help financial advisors alert their US person clients resident in Canada when they may need to seek advice from a qualified US tax professional. The key points are:

    • While there are constraints, RRSPs and RRIFs can provide effective tax sheltering of retirement savings.
    • TFSAs are not tax-exempt, and they carry stringent information reporting requirements.
    • RESPs and RDSPs are not tax-exempt, on top of which government grant money is taxable when paid into them. They are also subject to stringent information reporting, but some relief was announced in 2020.