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For high-income business owners and incorporated professionals, Individual Pension Plans offer a powerful way to save for retirement with higher contribution limits and tax-deductible contributions for the corporation. Retirement Compensation Arrangements are another, more complex, option for deferring compensation.

An Individual Pension Plan is a registered, defined-benefit pension plan that is typically set up by the corporation for a single, high-income employee, often the business owner or a key executive. It is designed to provide a predictable retirement income and offers significant tax advantages, especially for individuals aged 40 and over; incorporated business owners and professionals; consistent T4 high-income earners; and individuals seeking to maximize retirement savings beyond RRSP limits.

Individual Pension Plans minimize tax through several mechanisms, primarily by shifting deductible expenses to the corporation and allowing for substantial tax-sheltered growth, which is facilitated by:

• Corporate Tax Deductions for Contributions:

  • Employer Contributions are Tax-Deductible: The most significant tax advantage is that the contributions made by the corporation to the Individual Pension Plan are tax-deductible expenses for the corporation. This directly reduces the corporation's taxable income, lowering its corporate tax bill.

  • Not a Taxable Benefit to Employee: Unlike salary or bonuses, these contributions are not considered a taxable benefit to the employee when they are made. The tax is deferred until the employee receives pension payments in retirement.

• Tax-Deferred Growth within the Plan:

  • Tax-Free Investment Growth: The funds invested within the Individual Pension Plan grow on a tax-deferred basis. This means the employee doesn't pay tax on the investment income, capital gains, or dividends generated within the plan until the employee withdraws the funds in retirement. This compounding effect significantly accelerates wealth accumulation.

• Higher Contribution Room than RRSPs:

  • Maximizing Retirement Savings: Individual Pension Plan contribution limits can be much higher than RRSP limits, especially as the employee ages. This allows the employee to funnel a larger amount of money into a tax-sheltered environment, further reducing current income tax.

  • Past Service Funding: The ability to make lump-sum "past service" contributions for prior years of employment with the corporation allows for a significant one-time deduction for the corporation and rapid accumulation of retirement funds. This is a powerful tax-planning tool, especially for established business owners.

• Deductibility of Administration and Other Fees:

  • Corporate Deduction for Expenses: The corporation can often deduct the actuarial, accounting, and administration fees associated with setting up and maintaining the Individual Pension Plan. This further reduces the corporation's taxable income.

  • Interest on Borrowed Funds: If the corporation needs to borrow money to fund the Individual Pension Plan, the interest paid on that borrowing can also be a tax-deductible expense for the corporation.

• Terminal Funding at Retirement / Pension Splitting:

  • Additional Deductions at Retirement: When the employee approaches retirement, further lump-sum contributions, known as "terminal funding," may be made to the Individual Pension Plan to ensure the promised benefits are fully funded. These contributions are also tax-deductible for the corporation, providing another opportunity for tax savings, potentially in a year where the company has higher income.

  • Pension Splitting in Retirement: When the employee begins receiving their pension from the Individual Pension Plan, the employee may be able to split the pension income with their spouse, potentially reducing the overall household tax burden in retirement.

Taxpayers need to be aware, that as with most tax strategies, there are important considerations and potential drawbacks associated with Individual Pension Plans, as they are more complex and costly to set up and administer than RRSPs; and they requiring ongoing actuarial valuations and compliance with pension legislation; among other important legal considerations.

A Retirement Compensation Arrangement is a type of retirement savings plan, designed primarily for high-income earners, including business owners, executives, and professionals. It allows an employer (and sometimes an employee) to make contributions to a custodian (usually a trust) with the intention of providing benefits to the employee upon retirement, loss of employment, or a significant change in their services.

Retirement Compensation Arrangements offer several tax advantages, primarily through tax deferral and strategic timing of income, including:

• Employer Contributions are Tax-Deductible: When an employer contributes to a Retirement Compensation Arrangement, those contributions are immediately tax-deductible for the corporation. This reduces the corporation's taxable income in the present.

• Tax Deferral for the Employee: The contributions made to an Retirement Compensation Arrangement are not considered taxable income for the employee at the time they are made. The employee only pays personal income tax when they actually receive distributions (benefits) from the Retirement Compensation Arrangement in the future.

• 50% Refundable Withholding Tax: This is a key feature of Retirement Compensation Arrangements. When contributions are made to a Retirement Compensation Arrangement, 50% of the contribution (and generally 50% of any investment income earned within the Retirement Compensation Arrangement) must be remitted to the Canada Revenue Agency as a "refundable tax." While this might seem like an immediate tax, it's actually a prepayment of tax. When the employee eventually receives distributions from the Retirement Compensation Arrangement in retirement, a portion of this refundable tax is returned to the Retirement Compensation Arrangement. This effectively allows the money to grow in a tax-deferred environment.

• Lower Future Taxation (Income Splitting/Timing): The main tax benefit comes from the ability to defer income to years when the individual's income (and thus, their marginal tax rate) is likely lower, such as during retirement. By receiving Retirement Compensation Arrangement payouts when they are no longer in their peak earning years, they can potentially pay less tax overall on those funds than if they had received the same amount as current salary or bonus.

• No Impact on RRSP Contribution Room: Unlike Registered Pension Plans (RPPs), contributions to a Retirement Compensation Arrangement do not reduce the employee's Registered Retirement Savings Plan (RRSP) contribution room. This provides an additional avenue for retirement savings for high-income individuals who may have maxed out their RRSP and RPP contributions.

• Creditor Protection: Funds held within a Retirement Compensation Arrangement trust are generally protected from the employer's creditors.

• Flexibility in Withdrawals: Unlike RRSPs, there is no mandatory age to begin withdrawals from a Retirement Compensation Arrangement (such as age 71 for RRSPs), offering greater flexibility in managing income in retirement.

Nevertheless, as with most tax strategies, there are important considerations and potential drawbacks associated with Retirement Compensation Arrangements, including:

• Refundable Tax is Non-Interest Bearing: The 50% refundable tax remitted to the Canada Revenue Agency does not earn interest. This means that a portion of the contributed funds are held by the Canada Revenue Agency without generating returns until they are refunded.

• Complexity and Costs: Retirement Compensation Arrangements are more complex to set up and administer than simpler retirement plans, involving actuarial assessments for Defined Benefit Retirement Compensation Arrangements and ongoing management fees.

• Reasonableness of Contributions: Contributions to a Retirement Compensation Arrangement must be "reasonable" in the eyes of the Canada Revenue Agency. Excessive contributions could lead to the Retirement Compensation Arrangement being re-characterized as a Salary Deferral Arrangement, which has adverse tax consequences.

• Targeted for High-Income Earners: Due to their complexity and the 50% refundable tax, Retirement Compensation Arrangements are generally only beneficial for individuals with high incomes who have already maximized other registered retirement savings options.

In essence, a Retirement Compensation Arrangement helps minimize tax by allowing tax-deductible contributions now, deferring the employee's tax liability to a future date when their income tax rate is expected to be lower, and facilitating tax-deferred growth of investments within the arrangement, even with the 50% refundable tax mechanism.

For advanced tax planning, including legal advice and structuring of Individual Pension Plans and Retirement Compensation Arrangements, contact our law firm to schedule a confidential initial consultation with a knowledgeable tax planning lawyer at Chris@NeufeldLegal.com or 403-400-4092 / 905-616-8864.

 

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