Considering the historically favourable tax-deferral strategy of retaining and investing corporate earnings vs paying dividends, accumulating assets in a company has long been the default retirement plan for many business owners. Recent changes to how passive corporate income is taxed has renewed interest in a favourable but lesser-known alternative to retained corporate earnings and RRSPs, namely, the Individual Pension Plan (IPP).
Most of us are familiar with the common defined benefit pension plan. Based on a formula involving matching ratios, employee service with the company and income level, employees and their employer make regular contributions to the plan. In turn, the employee receives a guaranteed income stream from the plan in retirement. An IPP is just a smaller-scale, defined benefit pension plan sponsored exclusively for the owner of a privately-held company.
IPPs provide several retirement planning advantages over RRSPs while still sharing the same tax-deferral benefits:
- For those in their prime income-earning years, typically age 40 and beyond, IPPs allow higher tax-sheltering contributions than RRSPs;
- Retained corporate earnings and pre-existing RRSPs can be used to fund and help with ongoing contributions to the IPP;
- Contributions to the IPP and on-going maintenance costs are tax-deductible for the sponsoring company;
- IPPs allow investments in alternative asset classes otherwise exempt from RRSPs, such as private placements or limited partnerships;
- If investments within the IPP return less than 7.5% in any given year, the company may cover the shortfall through additional contributions. This is a tax-deductible expense for the company and a non-taxable benefit for the IPP owner. The flip side is that outperformance will reduce future years’ contribution levels;
- IPPs provide greater creditor protection vs. RRSPs;
- IPPs may allow tax-free wealth transfer to immediate family members employed by the company.
Compensation history and age are key factors
Consider Helen, a then-42-year-old business owner who earned $100,000 in the year 2000, taken as dividend income from her company. In 2001, Helen contributed the maximum 18% of her year-2000 earnings to her RRSP.
Fast forward 18 years to today, and Helen’s company is thriving. Over the years, Helen paid herself a modest salary, maxed-out her annual RRSP contributions and retained all other corporate earnings. Having heard about the new rules governing passive income taxation within Canadian corporations, Helen revisited retirement planning strategies with her accountant and decided to move forward with the RRSP-to-IPP switch after a thorough cost/benefit analysis.
Because IPP rules allow for higher contributions than RRSPs, Helen was able to retroactively top-up — or shelter — more of her annual earnings in her IPP. Continuing with the example above, Helen’s actuary calculated the difference between her year 2000 IPP-eligible contribution and what she contributed to her RRSP, then increased that figure to a 2018 inflation-adjusted amount. Her actuary performed the same calculation for all taxation years to 2000-2018.
By transferring her RRSP and using her company’s retained earnings top-up the newly-created IPP, Heather has established a fully-funded IPP whose value far eclipses that of her old RRSP. Further, her company was able to divest itself of otherwise taxable-on-withdrawal retained earnings and expense the IPP top-up amount.
- Though tax-deductible, maintenance costs for an IPP outweigh those of an RRSP. Actuaries are needed to initially assess whether the creation of the IPP makes sense. Measureable expense may be incurred only to discover the venture isn’t viable.
Actuarial considerations include:
- Current age;
- Past income — sometimes going back decades (as outlined above);
- The company’s ability to effectively fund the IPP with retained earnings;
- The owner’s RRSP situation.
- Where RRSP contributions are voluntary, the establishment of an IPP binds the company to make the annual contributions to the IPP. Marginally profitable firms and those without significant retained earnings are not good candidates for IPP sponsorship.
If you are a business owner, even if not necessarily classifed as a high-income earner (perhaps by savvy tax design), you should consider exploring an IPP with your accountant or portfolio manager. Both should be in a position to offer guidance and an actuarial referral.