Chapter 3: Retirement Planning for Business Owners Flashcards
What comprises earned income for a business owner (which determines an individual’s RRSP limit)?
Salary and taxable benefits, does not include dividends or repayments of shareholder loans.
What is the limit for accrued benefits (benefit entitlement) for DB pension plans?
An individual cannot have an accrued benefit in excess of 2% of their income up to the max in a given year.
How do you calculate the maximum income for RRSP deductions in a given year?
Maximum income is the previous year’s money purchase limit divided by 18%. 2022 MP was $30,780 / 18% = $171,000.
How do you calculate the maximum DB accrued benefit?
Maximum benefit is 2% of income up to the annual max. Can find max income as the prior year’s MP / 18% (i.e. $30,780 in 2023 divided by 18% = $171,000) x 2% = $3,420
When is pension income splitting allowed for various plans?
Available at any age for DB plans, only permitted for RRIFs, LIFs and other plans starting at age 65. IPPs also technically qualify for pre-age 65 income splitting, but that’s unlikely.
What is the criteria that a small business typically must have for an IPP to make sense?
- Good cash flow
- Incorporated
- Cash on hand beyond that needed for operations
- Owners who have taken T4 salary income over $100K annually regularly
- Owners who are 45+
- Owners who are likely to stay involved in their businesses for the indefinite future
- Owners who are planning for retirement
How is an IPP started?
An initial contribution must be made by the business to get the plan started. If the beneficiary has an existing RRSP, it would roll into the IPP as an initial funding requirement. If not, the company needs to make up the funding shortfall.
How are IPPs taxed?
Contributions made by the company are a tax deduction. Investment returns are tax deferred. The plan member only pays tax when an income is drawn in retirement.
Why does an IPP have creditor protection?
Because it is a Registered Pension Plan (RPP), so it benefits from the creditor protection afforded to all RPPs.
How do you calculate required IPP contributions?
This requires actuarial expertise. The max accrued benefit for a DB plan is 2% of earned income up to the max (2023 = $171,000 x 2% = $3,420). Using this as the annual PMT, we can solve for the required PV at age 65 (normal retirement age) to provide an annual PMT of $3,420 to a set mortality with a given discount rate. Once we have the PV at age 65, we can calculate the PV at the individual’s current age to determine how much the individual needs to set aside in the current year to fund the IPP.
In the example given, the business would need to set aside $29,513, but the RRSP limit for the year is only $27,230. This means that the business can fund the plan to a greater extent than if an RRSP or DC plan were used.
Why does the IPP not work for individuals under around age 45?
The spread between the required IPP funding and the maximum RRSP deduction limit increases as the plan member gets older (as there are fewer years until the scheduled retirement age). Under age 45, there is little benefit for an individual to set up an IPP.
What are the initial funding obligations for an IPP?
There is an obligation to fund an IPP for prior service when there is an employment history (specifically a history of salary). The amount required would need to be calculated based on past history (2% benefit entitlement based on salary and years of service). If the business owner has an RRSP, those amounts must be transferred first to match any initial funding obligations.
What is the initial downside of setting up an IPP?
Plan must be funded with any existing RRSP assets up to the required amount. This has the effect of moving non-locked in money into a locked-in account.
What is the legislated rate of return within an IPP? What happens if an IPP makes investments that return less than 7.5%?
If the IPP makes investments that return less than 7.5%, the business must make up that shortfall. This can be a benefit as it allows the business to transfer even more money on a tax deferred basis to the business owner.
How often does an IPP need to make up shortfalls due to investment returns not meeting the legislated rate of return?
IPPs must report to their pension supervisory authority every 3 years. If there is a shortfall between the investment returns of the plan and the legislated return (7.5%), the employer must make up a difference.
If an employer has to fund an IPP shortfall, what are the tax consequences?
If an IPP does not meet the 7.5% legislated return on their triennial reporting, a contribution to the IPP must be made by the business. This contribution is deductible to the corporation and does not create a taxable benefit or pension adjustment for the plan member.
What is meant by a terminal funding obligation of an IPP?
Terminal funding obligations arise when the plan member retires.
What are the 3 typical obligations that may create a terminal funding obligation for an IPP?
- CPP bridge benefits/early retirement benefits if the plan member retires before 65
- Obligation to provide survivor benefits if the plan member is married or in a common-law relationship (unless spouse has waived their rights)
- May be an actuarial calculation to adjust for inflation (indexing) when the plan member is retiring.
What happens if the plan member of an IPP retires before age 65?
Like other DB pensions, the IPP can be structured to provide a bridge benefit based on the CPP benefits that would be payable between retirement and age 65 (not a requirement).
The funding obligation at retirement is calculated using a straightforward TVM calculation for the annual CPP benefit at 65 and the number of years until 65.
How do you calculate the required funding for the survivor’s benefit of an IPP?
The length of time that the survivor’s benefit would (likely) need to be paid is based on the mortality of the plan member and the mortality of the spouse. For example, a male plan member may have a mortality of 90, and their female spouse that is 3 years younger could be assumed to outlive them by 5 years. The calculation would need to account for 5 years of survivors’ benefits being paid to the survivor at the plan member’s estimated mortality of age 90.
**This is purely an actuarial calculation, the funding available in the plan and rate of spending/investment income will determine what is left for the spouse if the business owner dies first.
How would you calculate the potential funding shortfall of an IPP if early retirement is taken?
Calculate the annual retirement benefit as the number of years x the annual benefit accrual. Then solve for the PV at the new retirement age to determine if the plan requires terminal funding to make up any shortfalls.
What are the administrative costs to set up an run an IPP?
Approximately $1-3K/year paid to an actuarial firm to administer the IPP (in addition to any investment management fees). These costs are paid separately (though they can be paid from within the IPP) and are a deductible expense for the business. The actuary who designs the plan should be consulted to determine the most efficient way to pay the costs.
What are the 3 options provided by an IPP for the purpose of retirement income? (How retirement incme can be taken)
- Defined Benefit Pension
- Transfer to a LIRA/LIF
- Life Annuity (copycat annuity)
What is the most common method of taking retirement income from an IPP?
A popular option in a low-interest rate environment is a copycat life annuity. Otherwise, transferring the plan into a LIRA/LIF is very common as it allows for more flexibility.
