Tag: Retirement

IPP – Individual pension plan enhancing savings for small business owners

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.

Commuting a defined benefit pension plan: Calculations and considerations

Leaving employment can be an emotional event, whether initiated by the employee, forced by the employer or undertaken in concert; for example, under an early retirement program. Obviously, it is also a significant financial event, with both current effects and life-long implications.

Where a defined contribution (DC) or defined benefit (DB) registered pension plan is in place, the departing employee will commonly have the option to continue in the plan, or to transfer to a new employer’s plan or a locked-in retirement account.

In the case of a DC plan, this is fairly straightforward.  On the other hand, the commuted value of a DB plan has to be determined by calculation, and can be particularly high in a low-interest-rate environment. While this clearly has its appeal, the procedure and tax implications are more complex. Ultimately, an informed decision should be tailored to fit the individual’s current needs and future expectations.

Commuted value of the pension

Under a DC plan (also known as a money purchase plan), the known element is the amount of the employer’s contribution obligation. These contributions grow tax-sheltered, with the amount of the pension based on accumulated value at the retirement date. If an employee departs prior to retirement, the plan may be transferred dollar-for-dollar into a locked-in retirement account.

By contrast, the employer’s obligation under a DB plan is to provide a calculated pension amount, irrespective of the contributions required to get there. An actuary is involved at the outset and on an ongoing basis in calculating the employer’s funding obligation, which will be adjusted from time to time according to past investment performance, future economic expectations, and the number and characteristics of plan members.

If an employee departs a DB plan prior to retirement, it will be necessary to obtain an actuarial report to determine the value of that person’s entitlement in the accumulating pension fund. The formula is deceptively simple:

[annual pension] x [present value (PV) factor]

The annual pension is the expected amount that would be due at the normal retirement date. That’s the easy part. On the other hand, the PV factor depends on a myriad of inputs, including:

  • Age at calculation date
  • Gender
  • Assumed commencement date
  • Any applicable reduction factor for early commencement
  • Continuation provisions (e.g., to spouse) and any guarantee periods
  • Indexation, if any
  • Adjustments that may be required by the jurisdiction’s pension legislation

The ‘how’ of combining these inputs is governed by the Actuarial Standards Board in section 3500 of its Standards of Practice for Pension Plans. Be forewarned if you plan to look this up; it is not for those who are faint of heart when it comes to arithmetic.

Maximum tax-free transfer

The commuted value from the actuary’s report should not be confused with the amount that can be transferred into a locked-in retirement account. The commuted value is essentially a property right between an employer and an employee, whereas the transfer amount is a fiscal issue between Canada Revenue Agency and a taxpayer.

The relevant rules are in Income Tax Act (Canada) section 147.3(4) and Income Tax Regulation 8517. In a similar manner to how the commuted pension value is derived above, the maximum amount that is transferable to a locked-in registered account is prescribed under the regulation as:

[lifetime retirement benefits] x [PV factor]

There are a number of factors affecting the lifetime retirement benefits figure, but at the core it is the annual pension the retiree would otherwise have been entitled to eventually receive.

The present value factor is laid out in a table in the regulation according to the person’s calendar-year age. It is 9.0 below age 50, rises to a peak of 12.4 at age 65, then declines to 3.0 for age 96 and over.

This PV factor is narrower than the commuted-value PV factor outlined above. For example, it doesn’t account for any indexing or early retirement benefits. As a result, the tax transfer value is often less than the commuted pension value. The difference or excess amount will be taxable in the current year, though the impact of this may be reduced if the person has RRSP contribution room and chooses to make a corresponding contribution.

Decision considerations

Apart from the value of the commuted plan and tax transfer, here are some surrounding issues to review before committing to a course of action:

  1. Investment of the commuted value may ultimately deliver a larger retirement income, but this should be balanced against downside investment risk
  2. Is the person comfortable leaving behind indexing and guarantees that may have been part of the original pension?
  3. Does the person wish to adjust income from year to year or ever make a lump-sum withdrawal? Subject to provincial limits, this will generally be possible only if the pension is commuted
  4. Some pension plans allow continued health and dental coverage. In contrast, a person in poor health may prefer to take the commuted pension due to a shorter life expectancy
  5. Spousal pension income splitting is available under age 65 from of a registered pension plan, but generally only on or after age 65 for an individual life income fund
  6. Beyond a spouse, a person may wish to leave a legacy to family or charity. Managing a commuted pension amount may be the easiest way to facilitate such a plan

Your quinquennial retirement check-in: A five-year tax retrospective

No, “quinquennial” is not part of my everyday vocabulary.  It is however a handy milestone for evaluating retirement planning progress, if not on an immediate personal basis then at least in terms of changes in the tax landscape.  

By its nature, the retirement/tax system evolves incrementally, principally in step with the annual federal budget process.  To those of us involved day-to-day in the financial advisory field, at times such change may seem to flow as slow as molasses in January.  By contrast, the general population might only contemplate these matters periodically – often only when prompted by their advisors – so developments may appear more momentous once brought to their attention.   

However, over the most recent five-year stretch, it could be argued that the sum of these developments is nothing short of astounding, whether planning your own retirement or advising others.  With that in mind, consider how the following items will affect retirement planning conversations today compared to a mere quinquennium ago.  

2008 – Pension income splitting

Technically a little outside the timeframe, pension income splitting was announced in the Halloween 2006 Economic Statement and introduced in the 2007 Budget.  The first opportunity to elect to split up to 50% of such income with a spouse would have been in filing one’s 2007 tax return in/by April 2008.  

In addition to the obvious potential to push income to a lower bracket spouse, the maneuver could help preserve the pensioner’s age credit, fend off OAS clawback and assist in making fuller use of the spouse’s pension credit.

2009 – Tax-free Savings Account

Introduced in the 2008 Budget, Canadian residents over the age of 18 received their first $5,000 annual allotment of TFSA room on January 1, 2009.  

The structure allows for contribution of after-tax funds, with any subsequent growth and withdrawals being tax-free.  In addition, there is a dollar-for-dollar credit on those annual withdrawals that increases contribution room the next January 1st.  Apart from being a welcome gift for those with excess cash to invest, the TFSA offers lower bracket individuals a more viable alternative or complement to the traditional RRSP structure.

The indexing formula boosted the annual dollar limit to $5,500 beginning in 2013.

2010 – Canada Pension Plan

While it is patently obvious that this is not a new program, the 2009 triennial review proposed significant changes to the CPP.  These changes were legislatively approved in 2010.

With the elimination of the work cessation test, it became administratively simpler to commence a retirement pension, and all future pensions will be marginally improved as the low earnings drop-out increases from 7 to 8 years.  However, the decision as to when to commence that pension has become more complicated with new mandatory premium payments for working beneficiaries (voluntary after 65), an increased monthly early take-up penalty from 0.5% to 0.6%, and an increased monthly deferral premium from 0.5% to 0.7%. 

2011 – Registered Disability Savings Plan

The RDSP was actually introduced in the 2008 Budget, but took 2 or 3 years of tweaking before those in the target population could fully avail themselves of the program.

A key benefit is the access to matching Grant and free Bond support money.  The 2010 Budget made provision for carryforward of unused Grant and Bond entitlements.  Perhaps the most important modification occurred in the 2011 Budget with the relaxation of stringent rules that up to then would have forced mass repayment of Grant and Bond money at inopportune times.  

The RDSP is now coordinated in many ways with the beneficiary aspects of RRSPs, RRIFs and RESPs, making for much more flexible planning options for individuals and families with disability planning needs.

2012 – Old Age Security

The 2012 Federal Budget will probably be most remembered for raising the OAS qualification age from 65 to 67.  Those born prior to April 1958 will remain eligible at 65, with those born after January 1962 having to wait all the way to 67.  The rest of us will be somewhere in between, with the phase-in period ranging from April 2023 to January 2029.  

As well, as of July 2013 an eligible individual may defer OAS pension for up to five years, in exchange for a 0.6% increase in the pension amount per month deferred.

2013 – Pooled Registered Pension Plan

As we head into the next quinquennium, the PRPP warrants mention before signing off.  

Discussed since 2010, the program is aimed at encouraging workplace savings where no current pension arrangement is in place.  The federal tax amendments out of the 2012 Budget are now passed, but there is yet to be any concrete action from the provinces.  As the program design dovetails contribution room with RRSPs, ever more opportunities and trade-offs may lie ahead, further feeding those retirement planning conversations.