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:
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- Transferring-in existing RRSP holdings;
- Making a deductible employee/personal contribution up to the amount of unused RRSP room; and,
- 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:
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- Take the pension pursuant to the terms in the pension agreement;
- Use the accumulated value in the IPP to purchase an annuity from an insurance company; or,
- 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.