You’ll have noticed a pattern by now: today’s post is Part 3 in a series on the role the Canada Revenue Agency plays in our lives. In total, this will be a four-post series, so stay tuned for next week as well.
In Part 1 and Part 2, I challenged business owners and incorporated professionals to stop whining about our silent partner and instead acquire working knowledge of corporate and personal taxation in Canada.
If you believe that taxation is beyond your level of expertise and blindly follow the advice (or lack thereof) from your advisors, I ask you to consider the following question: If Canada is expected to post a deficit in 2020-21 of $300+ billion, is it reasonable to assume that taxes will increase?
Given the possibility of higher taxes in the near future, business owners must make it a priority to defer and minimize their tax payments. I suggest this starts with a working knowledge of the tax code.
In Part 1, I discussed strategies for minimizing passive income and preserving as much of the Small Business Deduction limit as possible. I introduced a strategy called an Individual Pension Plan for corporate owners.
Today, I will discuss how we can add specific provisions to the IPP and enhance its usefulness for certain business owners.
Please note, these strategies are for illustration purposes and do not constitute as recommendations. I won’t and can’t cover all the different possible scenarios, so please speak with your advisors to determine if the strategies mentioned in the blog are appropriate for your unique circumstances.
Let’s start with the basics. What is a registered pension plan?
“A registered pension plan is a plan that provides you with a source of income during your retirement. Under these plans, you and your employer (or just your employer) regularly contribute money to the plan. When you retire, you’ll receive an income from the plan.”
So in short, it’s a plan that collects and invests funds during an employee’s working years and distributes the funds plus growth to the employee during retirement.
There are two main types of employer pension plans:
- defined contribution plans
- defined benefit plans
1) What’s a defined contribution plan (DC plan)?
In a DC plan, the employer and maybe employee (sometimes yes, sometimes no) contribute money to a pension plan, and the employee (again not always) selects the investment vehicle for the funds. When the employee retires, the pension plan is usually transferred to a locked-in registered retirement plan in the employee’s name, and the employee begins receiving a monthly pension until the plan is depleted or death occurs.
So the employee knows how much will be invested into the plan but doesn’t know how much will be available at retirement.
Here’s an example: assume X Corporation agrees to match employees’ contribution into a pension plan up to 3%, and assume employee John earns $100,000 in 2020.
If John contributes 3% to his company’s DC plan, X Corp. will match the contributions and John will see $6,000 added to his plan in 2020. John is responsible for selecting an appropriate investment vehicle, and we assume he invests in a five-year GIC with a 1% annual interest rate.
If we assume that his income, his employer and his investment choices don’t change for 25 years, John will save approximately $170,000. If we also assume John now retires from X Corp., he may transfer his pension to a locked in RRSP and may begin withdrawing income from age 55 or, alternately, start as late as age 71 (subject to minimum and maximum withdrawals).
Of course, there are many small-print items connected with DC plans which are not relevant for this general discussion. However, I want to emphasize that the risk of good or bad investment returns (before and after retirement) are borne by John and not X Corp.
Instead of purchasing a 1% GIC, John could have selected a successful investment strategy (like the Richard Dri Dividend Growth Model) and averaged, say, 10% during the same period. If he had, his retirement pool would then be approximately $590,000. And he would transfer this balance to his locked-in RRSP.
In short, the investment return risk is solely on John’s shoulders. If the returns are strong, John enjoys a better retirement. If the returns are poor, his retirement income suffers. On the other hand, X Corp.’s financial responsibility ends when John retires.
In real life, many employers are switching from defined benefit plans to DC plans, because a DC plan allows them to quantify their payments into the plan and limits their liability at the point of the employee’s retirement, not at the employee’s death.
2) What’s a defined benefit plan (DB plan)?
Under a DB plan, the employer agrees to pay the employee a specific pension income after they retire. The pension amount calculation is usually based on the employee’s salary, years of service, and an agreed participation percentage. The contributions are usually made by both the employer and employee (but can also be non-contributory for the employee).
As a simple example, Z Corporation has a DB plan which pays a pension at retirement based on the following formula: average salary during the last five years x number of years of service x participation percentage. Using John’s numbers, it looks like this: $100,000 x 25 x 1.5% = $37,500 per year in pension income (inflation coverage may also be included in some plans).
Without going into the weeds with the fine print, suffice to say that the risk of the pension plan lies with the employer. For example, if over the employee’s career, the pension plan’s investment returns are below projected or the employee lives to 100 years of age, causing a pension shortage, the employer is required to make up the shortfall with additional contributions.
In short, if my client had the choice of working with X Corp. or Z Corp. (all other things being equal), I would strongly suggest they accept employment with Z Corp. A DBP shifts the investment and longevity risk to the employer.
3) What’s an Individual Pension Plan (IPP)?
An IPP is a defined benefit plan for the shareholder(s).
In practice, the corporation that sets up the IPP is usually owned by the shareholder and their spouse; the shareholders are employees of the company; the shareholders wish to create a retirement plan; and the shareholders plan to reduce passive income earned in the corporation.
Using the above examples, John is the sole shareholder of X Corp. and his T4 income is still $100,000 per year. John hires an actuary to set up an IPP and plans to use the same formula mentioned above (average salary during the last five years before retirement x number of years of service x participation percentage).
During the IPP set up and every three years thereafter, an actuary determines the amount of money that is required to fund the pension, and the corporation follows the funding schedule and contributes annual tax-deductible payments to the pension. John starts receiving income from the IPP when he retires but no later than age 71.
An IPP allows business owners and incorporated professionals to create a defined pension plan similar to the DBP offered by large blue-chip corporations or organizations like the Ontario Teacher’s Pension Plan, the Ontario Municipal Employees Retirement System or Healthcare of Ontario Pension Plan.
4) Why should a business owner consider an IPP?
Here are some considerations:
a) IPPs allow more money to be saved for retirement than an RRSP.
b) IPPs recognize the years of past service and allow the corporation to make a one-time, tax-deductible contribution to fund the past service and increase the retirement income for the shareholder.
c) Customization of retirement benefits are possible, such as inflation protection, early retirement or CPP bridge benefit.
d) Assets in an IPP grow tax free until withdrawn by the employee/shareholder.
e) The assets are generally not subject to creditor seizure. Note: RRSPs in Ontario are not creditor-proof and may be included in a personal lawsuit.
f) All investment management and actuarial fees may be tax deductible by the corporation—unlike RRSPs where investment fees (such MERs) are not an expense for the individual.
g) All corporate contributions to the IPP are tax deductible, and any investment income is not attributed back to the corp.
h) Contributions reduce shareholder equity and may facilitate the eventual sale of the corporation.
i) The corporation may make additional tax-deductible contributions during negative markets.
j) Children employed by the corporation and earning a salary are eligible to become members of the plan, ensuring that assets pass to the next generation without taxes or probate fee.
Without going into too much actuarial jargon to answer this question, suffice to say that a business owner can add two additional accounts: a defined contribution (DC) account and an additional voluntary contribution (AVC) account to the IPP’s defined benefit (DB) account.
Yes, I am recommending three accounts in one plan: a DB plan, a DC plan and an AVC plan.
The defined benefit components hold the current and past service (including qualifying transfers). The defined contribution component holds 1% of T4 income. The additional voluntary contributions (VC) hold transfers in kind of RRSP assets in order to deduct investment management fees and provide creditor protection.
RRSP contribution limits are higher for shareholders under the age of 40; hence, IPPs are best suited for shareholders/employees over 40. However, with the additions I have described for you, an IPP allows younger shareholders to contribute to their AVC account until they turn 40, which means they can start accumulating funds sooner and may have a higher balance at retirement.
Conclusion
An IPP is a defined benefit plan (DB plan) for shareholders of a corporation. Because of the benefits mentioned above, it generally results in retirement balances greater than what’s available from RRSP contributions.
For additional cashflow flexibility and tax deductions (from transferring RRSPs into the additional voluntary contribution account), leading to a possible larger pension asset at retirement, shareholders should consider including a DC and AVC plan to their IPPs.
We offer you a range of services from creating bespoke financial plans and providing investment advice to helping you take advantage of our investment models. If you would like more information on the Wealth Navigator Process or our team, call me any time at 416.355.6370 or email me at richard.dri@scotiawealth.com.
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Nancy Pelosi
Nancy Pelosi made history in 2007 when she was elected the first woman to serve as Speaker of the House of Representatives. Now in her third term as Speaker, the 80-year-old was first elected to Congress in 1987 and is currently representing California’s 12th congressional district, which contains most of San Francisco. Pelosi was born and raised in a political family, with her father a Democratic congressman from Maryland who later became Mayor of Baltimore. Involved in her father’s campaign events as a child, Pelosi began her own political career soon after graduating from university, first working as an intern and then gaining an elected position 1976 as a Democratic National Committee member. With such a long career, Pelosi is best known these days for being the architect of President Obama’s Affordable Care Act (and then holding House Democrats united against Republican attempts to undermine it) and supporting Wall Street reforms, student aid, the end of pay discrimination for women, the repeal of the “Don’t Ask, Don’t Tell” policy, and energy legislation to help relieve the climate crisis. All this and so much more, while Pelosi has also raised five children, enjoys time with her nine grandchildren, and has no plans to retire. Nancy Pelosi
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