Tax-Effective Retirement

Business owners often keep the majority of their assets in their companies.  But what happens to those assets when you decide to start enjoying the fruits of your labours?  We have a number of options available to assist you in drawing income from your company in the most tax-effective manner.  Individual Pension Plans and Retirement Compensation Agreements are two of the most popular.

Individual Pension Plans (IPPs)

An Individual Pension Plan or IPP is a one-person maximum Defined Benefit Pension Plan which allows the plan member to accrue retirement income on a tax-deferred basis.

In recent years individual pension plans or IPPs have become a popular retirement savings tool for many executives. This is due in part to changes in provincial pension benefits legislation and to the active promotion of the potential advantages of IPPs by insurance companies and financial institutions. The primary candidates for IPPs are business owners, company executives and incorporated professionals over the age of 45 with an annual income greater than $100,000 per year.

An IPP is a defined benefit registered pension plan established for the benefit of a single employee. The annual retirement benefits funded by the plan are defined by the terms of the plan and are based on a percentage of the employee’s annual employment income. Unlike a group pension plan, the benefits payable can be designed to suit the needs of the individual beneficiary of the IPP. The IPP can be funded by employer and employee contributions or fully funded by the employer. To qualify as an IPP the employer must fund a minimum of 50 per cent of the required contributions.

The most significant advantage of an IPP is the allowable contribution limit, which is generally higher than the contribution limits available under an RRSP. This enables the plan beneficiary to accumulate a significantly larger pool of retirement savings than would otherwise be accumulated using an RRSP. Other potential advantages include:

  • The ability to make pension contributions in respect of past employment service.
  • A guaranteed amount of retirement income if the employer agrees to fund additional contributions should the IPP realize poor investment returns.
  • Participation by the employee in the investment decisions made by the IPP.
  • Protection from creditors of both the employer and the employee (under provincial pension legislation).
  • Multiple retirement income options (annuities may be purchased from an insurance company, funds may be transferred to an RRSP or the IPP may pay an annual pension).

Although the advantages related to an IPP are significant, there are several disadvantages that must be fully considered:

  • Unlike an RRSP, the funds will be locked in and access will be restricted until retirement.
  • It is not possible to split retirement income by making a contribution to a spousal plan, as is the case for a spousal RRSP.
  • Defined benefit plans have extensive financial statement disclosure requirements, and determining annual pension costs, asset values and liabilities is complex.
  • Set-up costs and annual operating costs are significantly higher than those associated with an RRSP (an IPP requires an actuarial valuation on set-up and every three years thereafter).

An annual filing with Canada Revenue Agency is required for IPPs. However, in recent years the market for IPPs has become more competitive and the costs associated with establishing and maintaining an IPP have been reduced.

Is an IPP right for you? The answer will depend upon your particular circumstances. You should consider reviewing the IPP option if you are within 15 to 20 years of retirement, have an annual income of over $100,000 and anticipate retiring with your current employer.

Retirement Compensation Arrangements (RCAs)

If you earn more than $125,000 annually, you can expect to experience ‘pension discrimination’ because of the cap on contributions in Registered Pensions Plans (RPP) such as Registered Retirement Saving Plans (RRSPs), Individual Pension Plans (IPPs) and Money Purchase Pension Plans (MPPPs). In other words, your pension benefits will be significantly lower than the acceptable standard of 70 per cent of pre-retirement income. Payments from an RCA combined with those from your RRSP, IPP, and/or Registered Pension Plan provide the total desired pension.

In the right circumstances a Retirement Compensation Arrangement, or RCA, could save you income taxes, provide golden handcuffs, retirement funding and/or help protect your assets.

RCAs are designed to provide supplemental pension benefits for senior executives and owner-managers, and are also used to provide pension benefits to an employee or an employee group in situations where a company does not have a registered pension plan in place. The rules related to the operation of an RCA are less rigorous than the rules related to the operation of a registered pension plan. As such, RCAs are extremely flexible and can provide an employer with a wide range of alternatives related to employee participation, funding methods and timing of benefits.

Operationally, RCAs are relatively straightforward. The terms of operation for the RCA are set out in the RCA trust agreement. The employer makes tax-deductible contributions to the trustee of the plan. The plan pays a special refundable tax each year equal to one-half of the contributions received plus one-half of the income and capital gains earned by the plan during the year. This tax is refundable to the plan on a basis of $1 for every $2 of benefits paid out during the year. The employee is taxed on benefits when they are paid out of the plan.

An RCA contribution must be reasonable in order to be deductible to the corporation. This is the same test that all corporate expenditures must pass. The contribution limits are often actuarially determined on the basis of providing the employee with a reasonable pension based on a percentage of the employee’s average annual income earned during his or her years of employment. This can result in significant catch-up contributions when you start the plan, particularly if the company has a history of paying large bonuses.

Various funding strategies are available to the company. The funding method is often selected based on the company’s cash requirements and its objectives in establishing the plan.

  • Cash funding— The company makes cash contributions to the RCA trust. One-half is used to pay the special refundable tax and the other half is invested. The RCA can loan the after-tax amount back to the company at a reasonable interest rate and with reasonable security. This can be a win-win situation for both parties. The company obtains financing at less than bank rates and the RCA earns interest at better than market rates. In some cases, arrangements can be made by the RCA to borrow against the refundable taxes and loan the proceeds to the company. In such cases the RCA loan arrangement has significant cashflow advantages over the traditional bonus and loan arrangements entered into by many owner–managers.
  • Insurance funding— The company funds a split-dollar life insurance policy under which the company is the beneficiary of the insurance policy and the RCA is the beneficiary of the investment component or tax-exempt surplus. Special refundable taxes must be remitted equal to the amount of the annual premium attributed to the taxexempt surplus. The benefit of this arrangement is that the investment income earned within the insurance policy is tax exempt and not subject to the 50 per cent refundable tax. As such, the investment compounds at pre-tax rates. The death benefit received by the RCA will be subject to tax unless it is paid out to RCA beneficiaries in the year received. Under this arrangement the RCA funds benefit from policy loans and death benefits received. The fact that these investments are secure from business risks is also attractive.
  • Funding from future cash flow — The company can undertake to fund the RCA out of future cash flow as the RCA’s benefit obligations come due. This arrangement provides limited current tax benefit to the company and can leave the employees at risk unless the company provides the RCA with some form of security. However, caution must be used when setting the security. The Canada Revenue Agency holds the view that the company has made a contribution if it provides the RCA with a letter of credit under which the bank encumbers specific corporate assets. This will result in a refundable tax liability equal to the amount of the encumbrance. On the other hand, a letter of credit secured by a floating charge on assets will result in a notional contribution equal to twice the annual fee.

As noted earlier, RCAs can be a useful component of a company’s retirement package by providing flexibility and cash-flow benefits. Depending on the circumstances, other possible benefits include:

  • probate fee savings, since pension benefits do not flow through the estate
  • tax savings if an employee ceases to be a Canadian resident after retirement
  • flexibility in timing of contributions, allowing contributions to track profitability
  • assistance in succession planning by ensuring retiring shareholders have sufficient retirement income

RCAs do have one key disadvantage — the refundable tax rate of 50 per cent results in a prepayment of tax because the top personal tax rate in all provinces is less than 50 per cent. This prepayment ranges from a high of 11 per cent in Alberta to a low of 1.4 per cent in Newfoundland. For most provinces the prepayment is approximately 3.5 per cent.

Consequently, RCAs are more attractive to Newfoundland residents and less attractive to Alberta residents.

You should consider discussing the use of an RCA with us if:

  • you are a shareholder in a private company with a history of income above the $300,000 small business deduction
  • your company has the liquidity to pay bonuses or RCA contributions
  • your company wants access to more capital
  • your company wants to reward key employees who have worked for the company for a number of years
  • you want to create a pension and grow it by reinvesting it in your business