Commuting a registered pension plan

The why, when and how to your decision

Whether you are headed into retirement or changing jobs at an earlier stage of your life, one of the largest financial decisions you face when you leave an employer is what to do with your retirement savings.

If you have been saving in your own registered retirement savings plan (RRSP), there’s not much more to say as it already belongs to you. Even when it is a group RRSP arranged through your workplace, generally the accumulated amount is yours to keep, though you’ll likely have to transfer to other investment choices.

If instead your work has a registered pension plan (RPP), there’s more involved.

Distinguishing registered pension plan types

You may be allowed to stay in your employer’s RPP, move to a new employer’s plan, or transfer into a locked-in retirement account. Depending on the type of RPP, that last option can be relatively straightforward, or it can be a multi-part process to arrive at the pension value, including potential immediate tax fallout.

Pensions come in two main varieties: defined contribution (DC) plans and defined benefit (DB) plans. Some plans are hybrid arrangements that have elements of both.

Defined contribution plans

Under a DC plan (also called a ‘money purchase plan’), the employer’s obligation is the amount to be contributed.

The employer as the pension sponsor must contribute a certain amount to the plan each year. Sometimes there may also be employee contributions. You will be able to choose among the investment options within the plan, with all income and growth tax-sheltered. The accumulated value is what is available to provide your retirement pension, which by default is paid as an annual annuity.

If you leave prior to retirement, the plan may be transferred dollar-for-dollar into a locked-in retirement account, where your investments may continue to grow tax-sheltered. The main feature of being ‘locked-in’ is that there is a maximum amount you can draw from it each year, which is intended to limit depletion so that it is sustainable through your retirement years.

Defined benefit plans

By contrast, under a DB plan the employer’s obligation is the pension benefit to be paid in future.

The employer must provide a retirement pension as determined by a formula. An actuary calculates the employer’s required contributions, based on the number of plan members and their respective rights. Those contribution amounts are adjusted from time to time according to past investment experience and future economic expectations.

You will be entitled to a retirement pension according to a formula in the plan (more on that below). If you leave before retirement and want to take your funds with you, once again an actuary is needed to determine the value. That’s where the complications really set in.

The remainder of this article focuses on commutation of a DB plan, first in terms of valuation and tax effects, and then on to how to approach this decision based on your particular needs.

Between you & your employer: Gross commuted value

A DB plan annual retirement pension is determined by multiplying a base income times a credit rate times years of employment. The base income and credit rate are negotiated between employer and employees. The base could be (for example) the average of your last five years of employment income, or better yet your best three years’ income. The credit rate generally ranges from 1% to 2% per year of employment.

If you leave prior to retirement, an actuary has to determine the value of your entitlement in the accumulating pension fund. On the face of it, it’s that annual pension discussed above multiplied by a present value (PV) factor. The PV factor is essentially an interest rate, but one requiring numerous inputs to derive, the main ones being current age, assumed commencement date (less any reduction for starting early), continuation provisions (e.g., to spouse), any guarantee period and any annual indexation.

The result is the lump sum current amount that would be required to pay the projected annual pension to you over your expected lifetime. For the sake of the calculation, it is assumed that the lump sum will be invested at long-term interest rates. Accordingly, commuted values tend to be higher when prevailing interest rates are low, and lower when interest rates are high.

Between you & the CRA: Maximum tax-free transfer to a locked-in plan

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.

In structure, the tax rule is similar to the commuted value calculation above. In tax terms, it multiplies your “lifetime retirement benefits” by a PV factor. In this case though, the PV factor is less generous 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. In a sense (though not literally), you might think of the tax calculation as what you would have accumulated under the RRSP rules, and therefore that’s the amount that you are allowed to transfer into a locked-in retirement account.

The excess amount will be taxable in the current year. While this is obviously not a pleasant prospect, it is applying tax to the more generous terms of the DB RPP, but you still get to keep the after-tax amount. The impact of this may be deferred if you have unused RRSP contribution room and choose to make a corresponding contribution.

Considerations before deciding to commute

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. Some people like to make investment decisions, while others shy away. A conversation with your financial advisor can help you decide.
2. Are you comfortable leaving behind indexing and guarantees that may have been part of the original pension?
3. Do you want to be able to adjust income from year to year, or ever make a lump-sum withdrawal? As locked-in plans put a cap on annual withdrawals, a commuted pension may be needed for this kind of flexibility.
4. Some pension plans allow continued health and dental coverage (at least for some period of time), which can relieve your budgetary costs in retirement.
5. On the other hand, if you have health concerns that may affect your life expectancy, you may prefer to take the commuted pension as a sure thing to be able to pass on the remaining value to your beneficiaries, especially if you have no spouse.
6. Spousal pension income splitting is available under age 65 from a registered pension plan, but generally only from age 65 for an individual life income fund. Does this affect your income plans?
7. Beyond a spouse, you may wish to leave a legacy to family or charity. Managing a commuted pension amount may provide an avenue for that kind of planning.

The TFSA Shuttle … channeling the Harlem Shuffle

A catalyst in concert with FHSA, RESP and RRSP tax-sheltered savings

In 1986, the Rolling Stones covered the 1963 R&B song Harlem Shuffle. While the original from the duo Bob & Earl was modestly successful, the Stones’ cover topped the charts in some places, peaking at #5 in Canada. The self-proclaimed world’s greatest rock’n’roll band had put their distinctive spin on something good, and made it even better.

Now, no-one’s about to suggest that tax planning is as enticing as a smooth groove, but magic truly can happen when good things come together. To the point, if you take one good thing
– FHSA for a home, RESP for education, RRSP for retirement – and combine it with another
– the ubiquitous TFSA – you really can produce a whole that is greater than the sum of its parts.

TFSA principles

Introduced in 2009, the tax-free savings account (TFSA) allows after-tax deposits to accumulate tax-sheltered and be drawn out tax-free. By contrast, a registered retirement savings plan (RRSP) is funded by pre-tax deposits that (also) accumulate tax-sheltered, and then are taxed on withdrawal.

Comparison of the two plans was inevitable, often framed as ‘TFSA vs. RRSP’. But rather than it being an either-or proposition, a more productive approach is to employ yes-and thinking. Specifically, if the TFSA is used as the entry point into RRSPs or other tax-sheltered plans, that routing can positively exploit a valuable feature unique to TFSAs.

The re-contribution credit

Whereas available room for other tax-sheltered plans is exhausted one-way as contributions are made, the TFSA calculation operates in both directions. For a Canadian resident over 18, annual room has three components:

- The prescribed annual TFSA dollar limit, currently standing at $7,000, +
- Unused room from previous years, +
- Withdrawals made in the immediately preceding year.

It is the third component that presents the opportunity for the TFSA to be used in concert (pun fully intended) with its tax-sheltered siblings. And whereas a catalyst in the chemical sense remains unchanged after influencing a reaction, not only might a TFSA help another plan, the benefit of that interaction can also echo back to the TFSA.

Start me up! (Assumptions)

Meet 20-something Mick. He’s a serial saver for current needs, and is ready to set aside an additional $100 each week to add to his routine. He intends on using a high-interest savings account (HISA) for this, with the going interest rate in early 2024 being 4%. It’s the start of the year and he hasn’t yet used any of his annual TFSA room.

Understanding there are 52 weeks in a year, to avoid a 19^th nervous breakdown doing the math, we’ll use $5,000 for the annual tally. As well, though his cash flow and the HISA terms are bound to vary, we’ll keep them constant here.

FHSA for a home

With the state of house prices, Mick knows he needs to start saving a down payment, for which he wants to use the recently-introduced first home savings account (FHSA). Base annual contribution room is $8,000, with a lifetime limit of $40,000. His plan will have him saving about $5,000 a year, using up his lifetime room in eight years.

Alternatively, Mick could open HISAs for both FHSA and TFSA. Assuming the same terms for each, weekly deposits could be directed to the TFSA, then after 50 weeks in mid-December the balance could be withdrawn and deposited to the FHSA before year-end. It’s important to be attentive to dates for two reasons:

- The TFSA re-contribution credit occurs the next January 1^st, which could be a 365-day swing if it’s missed.
- And though the deduction for FHSA contributions may be carried forward to a later year if desired, it can’t be carried back to an earlier year (i.e., there’s no ‘first 60 days after year-end’ rule as there is for RRSPs).

Timing aside, the average TFSA balance over the year will have been $2,500. At 4% interest, the mid-December balance will be about $5,100.

- An annual TFSA-out/FHSA-in shuttle of that full amount will allow Mick to max his FHSA in a little less than the eight years. With annual TFSA deposits of $5,000 and withdrawals of $5,100, the net re-contribution credit will be $100 each year, giving Mick $800 more TFSA room over the full duration by having used the shuttle option.
- If instead, an even $5,000 is taken out of the TFSA annually, it will again take exactly eight years to fill the FHSA, as if the TFSA had not been involved. However, by using the TFSA as a shuttle, $800 extra TFSA balance will be created, without making any material change to Mick’s investment choices or risk exposure.

RESP for education

Now in his 30’s, Mick had been hoping his son Jack would earn an athletic scholarship for his pole-vaulting prowess. But as he’s grown, it appears that Jack’s jumping skills were just a flash in the sand, and Mick now needs to catch up on contributions to the boy’s registered education savings plan (RESP). With carryforward of past unused room, Mick plans to deposit $5,000 for the next seven years or so, to claim the maximum grant money.

As with the FHSA example above, deposits could go direct to the RESP, or route through a TFSA. The Canada Education Savings Grant (CESG) is the main support program, matching 20% of annual RESP contributions, so $1,000 in our example. By routing through the TFSA, some of that CESG will be delayed a few months as compared to direct RESP contributions. Even so, that’s a small price to pay to obtain the additional TFSA balance or room, which will sum up to just over $700 across those planned years using the same HISA terms.

Another consideration is that once Jack is enrolled in a qualifying post-secondary program, personal RESP contributions can be withdrawn tax-free. The withdrawn amount could be routed back to Mick’s TFSA, assuming there is sufficient room. While the continuing income would be tax-sheltered whether left in the RESP or moved to the TFSA, once again the availability of the re-contribution credit favours use of the TFSA.

If Mick wants to take it a step further, some of those refunded contributions could go to Jack’s TFSA. After all, Jack’s entry into post-secondary will roughly align with him hitting age 18, when he will start getting TFSA room. This could be a good time to establish the knowledge, tools and behaviours to help him on his own personal finance journey.

RRSP for retirement accumulation

As Mick travels through his 40’s, 50’s & 60’s (though some observers feel like he’s the picture of eternal youth), his savings efforts will increasingly focus on retirement. The dollars will be larger – from the amounts saved to their accumulation and on to the annual drawdowns – but otherwise the same fundamentals apply. Mick could go direct into RRSP, or use a TFSA-RRSP shuttle, bearing in mind that larger amounts mean larger re-contribution credits.

There is one more effect to consider, being the annual tax refund Mick can expect to receive after deducting those non-workplace RRSP contributions when filing his annual tax return. If that too is routed to and through the TFSA, it will provide an extra lift to the anticipated TFSA re-contribution credit generated each year.

HISA or market investing?

Saving for retirement and being in retirement can each be decades in length. While a HISA may work for shorter-term purposes like a home purchase or education, it’s not suitable as the core of retirement savings. Indeed, a diversified investment portfolio is generally more appropriate for RRSP savings. In turn, a parallel TFSA portfolio could be arranged to facilitate the intra-year shuttle. With a higher expected (though variable and not-guaranteed) return relative to a HISA, this could be one more boost to the TFSA re-contribution credit.

Mick should consult with his advisor before undertaking this more advanced version of the shuttle concept, to determine what approach best aligns with his knowledge, personal circumstances and risk tolerance.

RRIF for retirement decumulation

Into his 70’s, Mick will have migrated his accumulating RRSPs into the decumulating form of a registered retirement income fund (RRIF) with mandatory minimum annual withdrawals. By default, he would probably take a fixed weekly or monthly spending withdrawal. Alternatively, he could take a lump sum early in the year and route it into a TFSA (HISA being most appropriate for this use), still available for spending, while getting one more TFSA room kicker.

TFSA as the others’ little helper

Over its 15-year history, the TFSA has progressed from novelty to fixture in our financial landscape. By using it as a shuttle, its built-in flexibility can feed into other tax-sheltered plans, while making itself better in the process.

Can a trust avoid tax on a deceased person’s RRSP?

A trustee’s tax liability has limits, a court case suggests

In February 2010, a woman learned she had only months to live and took steps to put her financial affairs in order. She executed a codicil naming one of her three daughters as executor of her estate. She named the same daughter the beneficiary of her RRSP, the only significant property she owned.

The woman told her daughter to use the RRSP proceeds to pay for the funeral, related family travel costs, final bills and estate administration expenses, and to distribute any residual funds equally with her two sisters.

When she died, the woman owed more in back taxes than the $76,616 in her RRSP. On receiving the RRSP proceeds, the daughter paid the expenses and distributed the rest as instructed. The Canada Revenue Agency (CRA) later assessed the daughter personally for the RRSP’s full amount.

In February 2021, the Tax Court handed down its ruling of the daughter’s appeal in Goldman vs. the Queen 2021 TCC 13.

How the CRA follows a tax debt

When someone who owes tax gratuitously transfers property to a non-arm’s length person, the CRA may use Section 160 of the Income Tax Act (ITA) to collect the tax debt from the recipient.

Consider a deceased taxpayer with an insolvent estate and an RRSP with named non-arm’s length beneficiaries. An RRSP is included in income in the terminal tax year when someone dies. The CRA will use Section 160 to collect from each beneficiary the proportionate share of tax owed from the RRSP income.

The Goldman case had an additional element: there was an existing tax debt that was larger than the entire RRSP even before the mother’s death. What is the extent of the liability for a named beneficiary in such a situation? And would receiving RRSP proceeds as a trustee make a difference?

Effect of a trust

The judge found that the three certainties for creating a trust had been met: the mother’s intention and identification of her daughters as beneficiaries were both clear, and her death caused the RRSP proceeds to fund the trust. The daughter received those proceeds in her capacity as trustee and was legally bound to carry out the terms of the trust as laid out by her mother.

As to the CRA’s contention that the daughter used her discretion to pay certain expenses instead of paying the CRA, the judge stated that she “received the RRSP proceeds to hold for the benefit of certain beneficiaries. The CRA was not one of those beneficiaries. However, that does not cause the trust to fail for certainty of object. The fact that the [government] dislikes the terms of a trust is not enough to declare it void.”

Even so, the court made it clear that Section 160 isn’t defeated by a trust. Rather, the question is whether the tax liability rests with the trust itself or with the trustee in their personal capacity. The judge said the trustee’s responsibility is to use the trust assets to satisfy tax debts, and that if those assets are insufficient, the tax collector “cannot simply seize the trustee’s personal assets.”

So who bears the tax?

Though the daughter wasn’t liable as trustee for the full RRSP proceeds, she was liable for three amounts:

A total of $8,139 was paid out of an account originally opened jointly for the daughter to care for her mother. Though these payments were in the nature of final expenses contemplated by the trust terms, they weren’t paid out of the RRSP proceeds. While the judge suggested that a reimbursement might have qualified per the trust’s terms, there was no evidence of any such reimbursement to this account from the RRSP proceeds.
The daughter was liable, as she conceded, for her $10,460 distributed portion of the RRSP residue.
Lastly, the daughter claimed $5,000 for legal expenses for the tax appeal. The judge ruled this was the daughter’s personal expense and not an estate expense.

The judge commented that, under a different ITA section that applies to trustees, the daughter could possibly be liable for the residue distributions to her two sister beneficiaries. However, that was not pleaded by counsel for the CRA. The court didn’t assess the two sisters’ liability.

In the end, the daughter was liable for $23,599. If the two $10,460 amounts (the residue to each of the other two sisters) were added, the total would be $44,519. Deduct that from the original $76,616 in the RRSP, and that leaves $32,097. Depending on your perspective, that’s either lost tax revenue or a tax-effective way to pay final expenses.

As this case proceeded under the Tax Court’s general procedure, it could stand as a precedent, so it will not be surprising if the government appeals. Regardless, if you have a client who is the executor for someone with tax debts, it would be prudent for them to clarify their obligations with legal counsel in order to steer clear of potential personal liability.