Oliver Continuing Education Series. Retirement Planning 2

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1 Oliver Continuing Education Series Retirement Planning 2

2 Copyright 2009 Oliver Publishing Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means without the prior written permission of Oliver Publishing. May 2007 Revised August 2011 ISBN Published by: Oliver Publishing 151 Bloor Street West, Suite 800 Toronto, Canada M5S 1S4 Tel: (416) Fax: (416) Toll Free Printed and bound in Canada

3 Retirement Planning 2 Contents Chapter 1 Review from Retirement Planning 1: How Much is Needed?... 1 Chapter 2 Government Pensions... 3 Determining the Amount of CPP Retirement Pension... 5 Summary of the CPP Retirement Pension... 7 Strategies To Help Clients Keep More Of Their OAS... 8 Chapter 3 Private Pensions... 9 Defined Plans... 9 Regulations for Registered Pension Plans (RPPs) Registered Pension Plan Taxation Registered Pension Plan Maximum Benefits Deferred Profit Sharing Plans (DPSPs) Group Retirement Savings Plans (GRSPs) Individual Pension Plans (IPPs) Summary of Registered Pension Plans Should a Client Opt Out of a Company Pension Plan? Chapter 4 Other Sources of Retirement Funds The Retirement Compensation Arrangement (RCA) Supplemental Executive Retirement Plans Reverse Mortgage Chapter 5 Registered Retirement Plans Registered Retirement Savings Plans (RRSPs) Determining Earned Income Withdrawals Withholding Tax The Pros and Cons of Owning an RRSP Self-Directed or Self-Administered RRSPs Non-Qualified Investments for Self-Directed RRSPs Locked-in RRSPs Chapter 6 Choosing The Appropriate Instrument For RRSP Maturity When To Annuitize? Annuities Immediate Annuities Deferred Annuities A Split Annuity Program i

4 Retirement Planning II Chapter 7 Post-Retirement Tax-Deferral Plans Registered Retirement Income Funds (RRIFs) RRIF Minimum Yearly Withdrawals RRIF Minimum Payments On Death of the RRIF Plan Holder Transfer of RRIF on Death of Plan Holder (annuitant) Advantages of RRIFs Locked-in Retirement Account (LIRAs) Life Income Funds (LIFs) Prescribed RRIFs (PRIFs) Life Retirement Income Fund Locked-in Retirement Income Funds ii

5 Chapter 1 Review from Retirement Planning 1: How Much Is Needed? Begin by estimating the client s expected expenses in retirement, in today s dollars. Using an assumed inflation rate, project these expected expenses to the year when the client expects to retire. For example, your client will require (in today s dollars) $50,000 per year in 20 years; assuming an average inflation rate of 3%, the future value of the $50,000, or the amount required in 20 years is calculated as: $50,000 = PV, 20n, 3i, COMP FV = $90, Next, estimate the before-tax income needed at retirement in order to generate sufficient after-tax income to meet the projected expenses. Use the client s current tax rate as a helpful guide for future tax rate, since this balances general increase in taxes over the period, with a decrease in income at retirement. Finally, calculate how much must be accumulated to generate enough income to meet retirement goals. Remember that the number of years that the client expects to live in retirement is important. A real interest rate is used for this calculation. This can be estimated by subtracting an assumed inflation rate from a given nominal interest rate (i.e., normal rate charged for mortgages). For example, if the nominal interest rate is 6% and the expected rate of inflation is 3%, the real interest rate is 3%. This rate is then used to calculate the present value of a client s retirement needs. 1

6 Retirement Planning II For example, if a client s yearly before-tax income required upon retirement (in future dollars) is $90,305, with a real interest rate of 3%, the amount that must be accumulated to generate enough income to meet retirement goals if the client expects to live 20 years in retirement (i.e., the present value of the client s income needs during retirement) is calculated as: $90,305 + PMT, 20n, 3i, COMP PV = $1,343,510 Determine the sources of revenue available at retirement: Estimate the amount received from each category of benefit (e.g., government CCP, private RRSP, private pension plans, etc.), and calculate the present value of the benefits at the date when they will be received. Adjusting the client s finances is the last step in the estimating process. This may involve a commitment to increase revenues through cutting expenses and consumption to enable larger contributions to a RRSP. It may also involve a decision to postpone or adjust the retirement date in order to ensure that the retirement goals may be fully realized. 2

7 Chapter 2 Government Pensions Canadian government retirement pensions include: Old Age Security (OAS) Guaranteed Income Supplement (GIS) the Allowance (formerly called Spouse s Allowance) Canada Pension Plan/Quebec Pension Plan (CPP/QPP) Old Age Security (OAS) pension is a monthly benefit payable to all Canadians or legal residents age 65 and over who apply for the benefit and meet residence requirements. The benefits are adjusted quarterly and are indexed to the Consumer Price Index (CPI). Benefits received from the OAS are considered taxable income. Residency requirements are: 40 years of residence in Canada after age 18 entitles a resident to a full pension. a minimum of 10 consecutive years of residence after age 18 entitles a resident to a partial pension. This is earned at a rate of 1/40 of the maximum pension for each full year of residence in Canada (e.g., the minimum pension is 10 x 1/40 = 25% of the full pension). certain temporary absences from Canada for employment or studies do not interrupt the qualifying periods of residence or presence in Canada. An application for OAS pension benefits can be made six months prior to eligibility, and must include proof of age, and legal residence status of the applicant. Payments begin the month after the month the applicant meets the requirements, but may be made retroactively for up to 12 months if the application is late. A person is entitled to receive payments while absent from Canada if he or she resided in Canada for a total of 20 years after age 18. Those with less than 20 years of residence can receive payments outside Canada for a maximum of six months. However, if a pensioner returns to Canada, payments will begin again in the month of his or her return. 3

8 Retirement Planning II OAS Clawback: Those who earn high incomes perhaps as a combination of income from private pension plans, registered plans, investments, and the CPP will have their OAS benefits reduced through a special tax known as the clawback. The clawback reduces benefits for those with a net income that exceeds $67,668 (in 2011) after most deductions, including those for RRSP contributions, have been made. It is calculated as 15% of the difference between income and $67,668. If net income exceeds $109,764 (2011), the entire OAS benefit is clawed back. Splitting CPP benefits can reduce the income of the higher-income spouse. Doing this can reduce or eliminate the clawback (see below). Guaranteed Income Supplement (GIS) is a monthly benefit paid to residents of Canada who receive the OAS and have little other income. The GIS is paid to those 65 and older who pass a yearly income test. The GIS is paid differently for single pensioners and for married pensioners. The amount a single pensioner receives is reduced by $1 for each $2 of other monthly income; the amount a married pensioner receives is reduced by $1 for each $4 of their other combined monthly income. Recipients must reapply annually for the GIS. Benefits are not taxed and are payable outside Canada for a maximum period of six months. The Allowance, formerly called the Spouse s Allowance, is a monthly benefit paid to residents of Canada who receive the OAS and have little other income. The Allowance is paid to a spouse (legal or common-law) of an OAS pensioner, or to a survivor. The applicant must be between 60 and 64 and meet income needs criteria. Canada Pension Plan/Quebec Pension Plan (CPP/QPP) have virtually the same requirements and benefits and for this reason are frequently discussed as if one plan. The distinction is that the CPP applies to all Canadians outside the province of Quebec; the QPP is for Quebec residents only. The CPP is available as a retirement pension, as a disability pension, and as survivor benefits. 4

9 Chapter 2-Sources of Retirement Income. The following concepts are fundamental to understanding how much will be received as a CPP retirement pension: contributions; the year s basic exemption (YBE); the year s maximum pensionable earnings (YMPE); pensionable earnings; average monthly pensionable earnings (AMPE). Contributions to the CPP are made by both the employee and employer, except when selfemployed. Pensionable earnings is the amount of income on which the pension contribution is based. Pensionable earnings are those employment earnings between the Year s Basic Exemption and the Year s Maximum Pensionable Earnings. The contribution is made at a rate of 4.95% in 2011 of pensionable earnings by each of an employee and his or her employer to a total of 9.9% in It is not possible to make additional contributions. If a person is self-employed, he or she is responsible for the entire contribution (9.9%). However, the portion of the contribution that represents the employer s share (4.95%) can be deducted from taxable income, as can the 15.25% federal tax credit for the employee s share of the contribution. Contributions are made by all those who work, including part-time employees, beginning at age 18. Contributions to the CPP are tax deductible; benefits received are taxable to the recipient. Contributions end when CPP payments start, at age 70, or at death. The year s basic exemption (YBE) is the amount of income below which CPP contributions are not made. It is currently pegged at $3,500. The year s maximum pensionable earnings (YMPE) is the amount of income above which contributions are not made. This amount is $48,300 in Determining the Amount of CPP Retirement Pension The amount of the monthly retirement pension is based on average monthly pensionable earnings (AMPE). AMPE is the total pensionable earnings divided by the number of months that contributions were made (or 120, whichever is greater). The monthly retirement pension at age 65 is 25% of the AMPE to a monthly maximum. 5

10 Retirement Planning II The steps to determine the monthly pension are: a) Determine Total Pensionable Earnings Add all pensionable earnings together = total pensionable earnings b) Determine Average Monthly Pensionable Earnings Take the greater of: Total pensionable earnings or 120 no. of months of contributions c) Determine monthly CPP retirement pension Multiply average monthly pensionable earnings x 25% = monthly retirement pension (to a maximum as defined in pension legislation). Early or Late CPP Retirement Options: A CPP recipient can elect to begin receiving his or her pension as early as age 60 and as late as age 70. If a recipient opts for an early entitlement, the pension is reduced by half a percent (0.5%) for each month the recipient is younger than age 65. The recipient must not receive employment income in the month the first payment is received and the month prior (or be no longer employed) or has an income lower than would be received as a CPP payment. When the pension is delayed, it is increased by half a percent (0.5%) for each month the recipient is above the age of 65. Benefits are capped at age 70. CPP Death Benefit: When a CPP contributor dies, a death benefit is payable to his or her estate. The benefit is equal to the total payment that would have been received by the contributor for six months at age 65. The maximum death benefit is $2,500. Pension Sharing: There are three circumstances under which a CPP pension can be shared: by assignment; upon separation or divorce; after the death of a CPP contributor. Assignment: Spouses or common-law partners who have contributed to the CPP and are at least 60 years old can share their retirement pension. The sharing of a CPP pension is called an assignment. The assignment of CPP redistributes income from a pension or pensions; the amount of pension is not increased or decreased by assignment. An assignment will end on divorce, if a non-contributor spouse becomes a contributor, on death of either spouse, or one year after the spouses separate. 6

11 Chapter 2-Sources of Retirement Income. Separation or Divorce: In the case of marriage breakdown, whether legal or common-law, the spouses can divide pensionable earnings equally. The spouses must apply for the division within three years of the date of marriage breakdown. Death: After a CPP contributor dies, the spouse may apply for a surviving spouse s pension. This pension can be received by a legal or common-law spouse. The amount the surviving spouse will receive depends on how long contributions were made to the plan, the age of the spouse when the contributor dies, whether the spouse is receiving a CPP pension, if the spouse is disabled, and if there are dependent children. Summary of the CPP Retirement Pension benefit payment clawback contribution period contributions contributors death benefit exempted from plan inflation protection participation tax not automatic; the recipient or a person acting in the capacity of his or her power of attorney must apply none: pension is paid without consideration for other assets and income Canadians aged 18 to the month the person receives first pension payment, and to age 70 if the person continues to work until that age 4.95% of employment earnings contributed by both employee and employer above the Year s Basic Exemption up to the Year s Maximum Pensionable Earnings or a total of 9.9%; self-employed contribute full 9.9% employees and their employers; self-employed yes, to a maximum $2,500 lump sum casual and migratory workers; those employed in agriculture, fishing, and forestry; and those with annual income less than $250 pension and benefits are linked to the Consumer Price Index and are adjusted annually compulsory for Canadian employees, with exemptions as noted above, including those who are self-employed; program is portable and is not interrupted by changes in employment contributions are tax deductible; pensions and benefits are taxable to the recipient 7

12 Retirement Planning II Strategies to Help Clients Keep More of Their OAS The government claws back payments of Old Age Security benefits. Pensioners with an individual net income above $67,668 (2011) must repay part of the maximum Old Age Security pension amount. The repayment amounts are normally deducted from their monthly payments before they are issued. The full OAS pension is eliminated when a pensioner's net income is $109,764 (2011) or above. Strategies to minimize a client s income level so that they can avoid some or all of the clawback: if it is not possible to avoid the clawback every year, aim to avoid the clawback in some years; have the client start receiving CPP earlier to reduce the amount of income received yearly; suggest the client splits the CPP and/or other pension benefits with a spouse; have the client maximize RRSP contributions and defer the deduction until the OAS starts; have the client repay any outstanding balances for the RRSP Home Buyer s Plan or Lifelong Learning Plan; before the client turns 64, realize capital gains that would be due by the time the client turns 71. It will be necessary to weigh whether the client is better off facing the resulting tax bill and losing less in OAS benefits later or to hold the investment longer. use a prescribed annuity instead of traditional fixed-income investments for the lower taxable income that will be received; split funds withdrawn from a RRSP or RRIF with the client s spouse if he or she is in the lower tax bracket; ensure clients pay off all debts before age 64 so that they do not have to have a higher income for debt payment; move money from investments that generate interest or dividend income to investments with deferred capital gains. The gain will be deferred until the investment is sold or until the death of the client. suggest the client use a line of credit rather than withdrawals from RRSPs or RRIFs to meet cash-flow needs; consider moving a client s investment portfolio into an investment holding company where the income will be taxed in the name of the corporation; move a client s investment portfolio into an inter vivos trust, since the clawback does not apply to income earned in an inter vivos trust. Income can be paid to the client or left in the trust to grow. consider a reverse mortgage to withdraw income from the home. Income received must make the costs of setting up the mortgage and interest costs worthwhile. While minimizing tax is a good strategy, it should not be the basis for every decision. Tax rules can change and make earlier choices of dubious benefit. 8

13 Chapter 3 Private Pensions Private pensions are those pensions established by employers for the benefit of their employees. These pension plans are called Registered Pension Plans (RPPs), and although they are registered (with Canada Revenue Agency), they are a separate category of pension plan than Registered Retirement Savings Plans (RRSPs). An employer-sponsored RPP can take the form of a: defined plan; deferred profit-sharing plan (DPSP); group Retirement Savings Plan (GRSP). Defined Plans An RPP defined plan is either: a defined benefit plan, or a a defined contribution plan (also called a money purchase plan). Defined Benefit Plan Employers and employees both contribute to a defined benefit plan. Employees with a defined benefit plan know exactly how much they are going to pay for the pension and how much they will receive when retired. The employer, however, does not know precisely how much it is required to contribute to the plan, since the amount of capital needed to provide the pension will be affected by interest rates during the period of accumulation. This probably accounts for a decrease in the number of defined benefit plan pensions from 44% to 34% for all Canadians enrolled in a pension plan between 1992 and

14 Retirement Planning II All funds contributed to a defined benefit plan are locked in to ensure that the plan member has an income upon retirement. A pension plan member who wishes to transfer his or her plan out of the employer-sponsored plan will find that he or she must place the funds in a plan that restricts the cash-out. Such plans are called locked-in plans. Transfer options for locked-in funds are: a Locked-in RRSP also known as a Locked-in Retirement Account (LIRA); a Life Income Fund (LIF) (in all provinces except Saskatchewan); a Locked-in Retirement Income Fund (LRIF) (in Newfoundland and Manitoba); a Prescribed RRIF (in Saskatchewan and Manitoba); a deferred life annuity (i.e., annuity payments would commence at retirement age); another Registered Pension Plan (where the plan permits). On retirement, the funds from a defined benefit plan can also be used to purchase a life annuity. There are four types of defined benefit plans: career average earnings plans; final average earnings plans; best earnings plans; flat benefit. A career average earnings plan records a pension credit in every year of employment. Employees contribute a fixed percentage of earnings and the employer contributes the amount needed to raise the fund to a level sufficient to provide the total pension credit for that year. Since an employee typically earns less when he or she first joins a firm than later, the amount of pension will be decreased by the lower-income years. In a final average earnings plan, the final income-earning years (usually the highest incomeearning years) are used as the basis for determining the pension income. A best earnings plan bases pension benefits on an average of the best years of pensionable earnings, usually three or five consecutive years. A flat benefit plan specifies the age and the number of years of service that are required before the employee is eligible for the benefit. Final-average earnings and best-earnings plans usually produce larger pensions. 10

15 Chapter 3-Private Pensions. Past Service Benefits If an employee works for an employer without a pension plan, and then a pension plan is put in place, that employee can receive a pension contribution paid by the employer for the years prior to the implementation of the pension plan. This is called a past service benefit. These benefits are funded by the employer alone. Typically, the pension credit for each year of past service benefits is reduced (e.g., from 2% to 1%), because the employee is not contributing towards cost. Defined Contribution Plans A defined contribution plan, also called a money-purchase plan, also pools defined contributions of the employer and the employee to provide the pension. The differences between a defined contribution plan and defined benefit plan are: the employer knows precisely how much must be contributed with a defined contribution plan an employee with a defined contribution plan does not know how much he or she will receive as a pension, because interest rates and investment earnings will have an impact on the total value of the pool of funds that is contributed employees have a choice of investments to which their money can be directed with a defined contribution plan. These investments are the same investments available to the self-directed RRSP plan holder. A defined contribution plan is also locked-in. An employee has the same options on retirement as one with a defined benefit plan. This plan is popular with small employers, since it is: easily understood; easily administered; has fixed annual costs. The regulations relating to money- purchase plans are not as exacting as those for defined benefit plans. Employees like these plans because they have a choice of investment vehicles to purchase with the funds. Disadvantages The amount of the pension remains unknown until retirement. If the investment performance of the fund has been inferior, a smaller pension results. 11

16 Retirement Planning II Members retiring under similar circumstances can receive completely different pensions. Regulations for Registered Pension Plans (RPPs) Provincial legislation covers: pension eligibility; vesting; locking-in; portability of pensions; survivor s benefits; inflation indexing. Eligibility Vesting Locking-in Portability All full-time employees with at least two years of continuous service, and all part-time employees who have two years of continuous service and whose annual salary is 35% or more of the year s maximum pensionable earnings (YMPE), are eligible to join their company s pension plan. When an employee switches jobs, the employee is entitled to keep the previous employer's pension contributions if there has been two years of employment. The right to keep these contributions is known as vesting. Locking-in is when money is locked in to an RRSP, a Locked-in Retirement Account (LIRA), Life Income Fund (LIF; not available in Saskatchewan), until the employee retires or to a date specified in the plan (see other options above). Locked-in funds must begin to be brought into the income of the retired employee no later than the year following the calendar year in which the employee turns 71 or, if rolled into another registered plan that will continue to defer income and tax (e.g., RRIF), the plan must make minimum income payments. An employee with vested contributions in a RPP who changes employment is entitled to: transfer these funds to a LIRA or other locked-in option; transfer the funds to another RPP of the new employer; transfer the funds to an insurer to purchase an annuity; or keep the funds with the existing pension plan until retirement. 12

17 Chapter 3-Private Pensions. Survivor s benefits Most plans provide members with a number of options regarding the payment of their pension after their death. Most provinces specify that the spouse must receive at least 50% of the pension upon the death of the pensioner, unless he or she specifically renounces that option in writing when choosing the pension benefit. Options may include: a specified guaranteed payment period; a Joint and Last Survivor benefit, at amounts that vary from 50% to 100%; a 50% spousal benefit; or a combination of these options. Inflation indexing RPPs are adjusted for inflation in accordance with increases in the Consumer Price Index. Registered Pension Plan Taxation RPPs must comply with regulations in the Income Tax Act that specify maximum amounts that may be contributed to the plans and deducted from income. Employer contributions to RPPs are tax deductible if paid within the taxation year or up to 120 days thereafter. Employee contributions must be made by December 31 in the year a deduction is claimed to be tax deductible. Employees are not taxed on the employer contribution as an employee benefit, but they are taxed on the pension income when it is received (usually following retirement). Some plans require or permit the employee to make additional contributions to the plan. These additional payments can be deducted for tax purposes in the year in which they are contributed. When an employee begins to receive pension income, it is taxed as regular income, although 15.25% of qualifying pension income, up to $2,000 per year, may be exempted by the pension income credit ($1,000 per year in Quebec). 13

18 Retirement Planning II Registered Pension Plan Maximum Benefits The maximum yearly pension that can be provided by either a defined benefit plan or defined contribution plan: o 2% per year of the final average or best average earnings for a stated period before retirement by the years of service (e.g. monthly pension = 1.5% x average monthly earnings of last 5 years x years of service). Deferred Profit Sharing Plans (DPSPs) A Deferred Profit-Sharing Plan (DPSP) is a trust created for all employees of a company, or one or more classes of employee of that company (such as executives), and registered with Canada Revenue Agency. A trust company acts as trustee. In order to be registered, a DPSP must provide for employee vesting. A DPSP cannot be registered if any of the beneficiaries of the plan are related to a shareholder who owns more than 10% of the voting shares of the company. Only the employer makes contributions on behalf of the employees who are members of the plan. The contributions and earnings accumulate in the plan tax-deferred, and can be withdrawn upon retirement or earlier, once the contributions have vested with (are placed under the control of) the employee. Contributions are limited to 18% of pensionable employee earnings for the year, to a maximum ($11,485 in 2011). An employer can make contributions up to 120 days after the fiscal year-end of the company. The DPSP must set out the effective date and eligibility of the participants. It must clearly stipulate: retirement age; death and termination benefits; how payments are to be made; how the plan can be amended or terminated. How DPSP Funds Are Invested Qualified Deferred Profit-Sharing Plan investments are similar to RRSPs, except a DPSP is prohibited from holding employer debt. However, a DPSP is allowed to purchase Treasury shares of a qualified employer-company (that is, the company that is the employer). 14

19 Chapter 3-Private Pensions. Benefits and Withdrawals from a DPSP The employer must pay all vested amounts to the employee (or the employee s estate) within 90 days after death or if the employee terminates his or her employment. Partial withdrawals from vested funds are possible. Payments, which must start within 90 days following the employee s retirement or the employee s 71 st birthday, whichever is earlier, can be paid to the employee as: lump-sum cash and/or stock; periodic payments for no more than a 10-year period; a life annuity. Taxation of Funds Withdrawn from a DPSP All benefits received by employees are taxed as ordinary income, except for accumulated capital gains on employer shares transferred to the plan, which are taxed as capital gains. Assets accumulate in a DPSP tax-free, and cannot be transferred, assigned, or used as loan collateral. A DPSP can be transferred to a Registered Pension Plan (RPP), RRSP, or another DPSP plan as long as the new plan has at least 10 members and has existed for one year. If common shares in a DPSP are transferred to the employee as a payment for his or her withdrawal, retirement, or death, any capital gain is not taxed as a benefit to the employee, but is deferred until the stocks are sold. Group Retirement Savings Plans (GRSPs) Group Retirement Savings Plans (GRSPs) provide benefits similar to those offered by individual RRSPs, except the employer, union, or professional association administers them on a group basis. Employees or members contribute by wage deduction, matched wholly or partially by the employer, union, or association. All employer contributions are deductible by the employer as salary payments and taxable to the employee as salary received. Group RSPs are not locked in, and can be cashed whenever the employee decides, depending on the terms of the plan. 15

20 Retirement Planning II Individual Pension Plans (IPPs) An IPP is a registered pension plan set up for one person. It specifies the level of payments to the plan holder. The employer is responsible for making annual contributions. The high set-up and administrative costs are tax deductible. IPPs allow for higher tax-deductible contributions than those under an RRSP. benefit payment benefits for survivors contribution by employee contribution by employer contributors eligibility Summary of Registered Pension Plans Defined benefit plan Defined contribution plan unknown by employee options provided for survivor Deferred profitsharing plans known by known by employee employee options provided options provided for for survivor survivor known known not allowed known unknown known the lesser of 18% of annual employee earnings or $10,000/employee employees and employees and employers only employers all full-time and part-time employees with at least 2 years of continuous service; annual salary must be 35% or more of the year s YMPE employers all full-time and part-time employees with at least 2 years of continuous service; annual salary must be 35% or more of the year s YMPE all full-time and part-time employees with at least 2 years of continuous service; annual salary must be 35% or more of the year s YMPE Group retirement savings plans unknown by employee options provided for survivor known employees and employers all full-time and part-time employees with at least 2 years of continuous service; annual salary must be 35% or more of the year s YMPE inflation at the discretion at the discretion not applicable not applicable protection of the employer of the employer locked-in yes yes yes no options on retirement LIRA, LIF, or life annuity LIRA, LIF, or life annuity lump sum payment; stock; periodic payments; life annuity portable yes yes yes yes RRSP, RRIF, lump sum payment, annuity 16

21 Chapter 3-Private Pensions. taxation of benefits taxation of contributions as income as income as income as income contribution by employee is tax deductible contribution by employee is tax deductible there is no employee contribution, and therefore no tax deduction vested yes yes yes; allows for partial withdrawals contribution by employee is tax deductible yes There are two types of IPPs: 1. A Shareholder Pension Plan for owner/managers who own more than 10% of the shares of the company. 2. An Executive Pension Plan for new shareholders or those who own less than 10% of the shares. These are often used as an executive perk to attract or retain senior management. IPPs are not open to a partner, a proprietor of a company, or to people who are self-employed and do not have employees. People in the 40 to 60 age group, earning in excess of $100,000 per annum, find these most attractive. The IPP plan holder may still make a contribution to his or her RRSP or a spouse s plan. IPP funds are locked-in. As retirement nears, the plan holder can transfer the funds to a locked-in RRSP. An IPP is creditor-proof; creditors cannot have access to these funds. This further defers tax until age 71, when the locked-in RRSP must be used to purchase a life annuity or a Life Income Fund. Should a Client Opt Out of a Company Pension Plan? Most Canadians are not members of a company pension plan; their employers provide no plans and leave retirement planning up to the individual employees. Opting Out of a DBP If the company plan is a DBP, the amount that can be transferred to a locked-in RRSP is the commuted value. This is the present value of the pension benefit earned to date. The present value is tied to the yield on the Government of Canada long-term bond. 17

22 Retirement Planning II Therefore, the commuted value is higher when interest rates are low than when interest rates are high. If a client is retiring and is staying in the DBP, he or she may be entitled to ongoing benefits from the company (e.g., extended health and dental coverage). The key difference between a locked-in RRSP and a DBP is that there is no investment risk to the employee with a DBP. The retirement benefit does not depend on market performance. After the money has been transferred from the DBP, the employer no longer has any obligations to the employee or his or her retirement income. Opting Out of a DCP or a Group RRSP The amount that employees can transfer from a DCP or a GRSP is typically the amount of contributions paid into the plan, plus any earnings. If a client is retiring, he or she may be entitled to ongoing benefits from the company (e.g., extended health and dental coverage and group life insurance), if he or she leaves the money in the plan. Clients must be sure that they are not losing company benefits by opting out of a DCP or GRSP. The decision to transfer money from a DCP to a locked-in RRSP or from a GRSP into a selfdirected RRSP means the client must be confident that he or she can manage the money better than the pension plan manager. A locked-in RRSP usually provides a greater range of investment options. An important comparison that must be made is the cost of managing the money in a DCP versus a RRSP. In the DCP, the cost can be as low as 0.25 %, compared to between 1% and 2% in an RRSP. Opting Out from the Client s Perspective A client may wants to opt out of the company plan because of termination of employment by the company or for other reasons (e.g., to sever any connection with the company out of bitterness or out of concern for the company s solvency). The decision to opt out should be made objectively. There may be situations in which the client should opt out but, in many cases, opting out is not in the client s best interest. The advisor s fiduciary responsibility is increased when a client opts out because: the sum transferred may be larger than the client has ever had to deal with before; the client may be inexperienced in handling investment decisions. 18

23 Chapter 3-Private Pensions. Reviewing the Facts with a Client The financial differences between staying in a Defined Benefit Pension plan and opting out can be made clear to the client if the advisor draws up a scenario that illustrates just how much money the client could expect by staying in the plan. To do this: use a rate of return comparable to the long-term Government of Canada bond rate to show the basic benefit value under the plan and to make the commuted value more meaningful; consider the client s risk profile: A client who is not risk averse and has some investment experience might see a larger income benefit over the long term by opting out. A client who is risk averse and has limited investment experience might earn a lower retirement income by opting out. set out a worst-case scenario (e.g., what would happen if there was a dramatic fall in the markets); show the income that would be received at the normal retirement age of 65 if the client converted to a locked-in RRSP or to a Life Income Fund (LIF) (NB: The LIF has minimum and maximum amounts that can be withdrawn each year, unlike the RRIF); compare the income that the client would receive from a pension and from a LIF if the client starts withdrawing money at 65 or earlier. Situations in which a client might be better off taking the commuted value of the pension plan include: when it is more than seven years before the pension income is to be paid (the pension income is probably frozen and not linked to inflation during that time); when the pension plan offers guaranteed partial or occasional adjustment indexing; when the client and spouse have a shorter-than-average life expectancy; when the client is single and wants to leave a larger estate. Occasional anomalies may make the commuted value of the pension plan larger than it would normally be (e.g., if there has been a year or two of unusually high income due to performance-related pay). For these clients, the recommendation to stay or opt out of a private pension plan should be based on: what company benefits the client would get if he or she remained in the plan; when the client wants to retire, since a short time horizon will require more risk to be assumed in an effort to achieve the same income as a pension plan; the client s investment experience and risk profile; how the benefit will affect their lifestyle in retirement (e.g., a client whose spouse has a generous guaranteed pension has more flexibility than a client with a family to support) 19

24 Retirement Planning II how long the client is likely to live (with a DBP, the income lasts until the death of the pensioner, while with a self-managed account, there is no guarantee); whether the income is fully or partly indexed against inflation; whether the client s spouse will be provided for if the client opts out. As a survivor, the spouse is entitled to a benefit of no less than 60% of the pension plan, although this right can be waived. The client has to decide whether the spouse should receive a guaranteed amount or be responsible for managing the plan. Once the scenarios are complete, the recommendations should be set out in writing for the client. Ensure the client understands that the numbers are only estimates and not a guarantee of future returns. 20

25 Chapter 4 Other Sources of Retirement Funds The Retirement Compensation Arrangement (RCA) A Retirement Compensation Arrangement is not a pension plan. An RCA, as defined in the Income Tax Act, is a way for employers to pre-fund retirement benefits. The RCA has no effect on an RRSP. An RCA is established by the employer as a taxable trust. The trust holds the funds for retirement. There are many investments eligible for an RCA, including life insurance, stocks and bonds, mutual funds, and deferred annuities. The investments are governed by the trust agreement instead of the Income Tax Act. The employer receives a deduction for contributions made to a RCA; a 50% refundable tax applies to payments made to the trust. The tax is remitted to the CRA when the contribution is made and refunded when the payment is made to the employee. The employee reports the income for tax when received from the custodian. The custodian of the RCA reports to Canada Revenue Agency annually, summarizing the account. The costs of setting up and administering an RCA are: the legal cost of establishing the trust; the cost of preparing the annual tax return; the cost of the custodial services. 21

26 Retirement Planning II RCA arrangements are used by: owners of privately-held corporations; corporate executives making more than $85,000 annually; people who might retire outside Canada. Supplemental Retirement Plans ( Top-Hat Plans ) The Income Tax Act aims to equalize the tax benefits of RRSPs and group pension plans. However, tax-assisted savings under the RRSP are maximized at just over $105,000; taxassisted benefits under the Defined Benefit Pension plan are maximized at approximately $100,000. Benefits for senior executives and employees who have maximized other plans can be obtained through a supplemental retirement plan. Typically the employer agrees on an additional amount that will be paid on retirement to the employee. When the amount is unfunded, there is no tax liability to employer or employee. The employee must trust that the employer will be able to pay the promised benefit. Reverse Mortgages Reverse mortgages (also known as home equity conversion mortgages) are new products aimed at retirees who find themselves cash poor and house rich. With a reverse mortgage, seniors in this position can borrow against the equity in their homes while continuing to own the titles to their homes (and continuing to be responsible for taxes and upkeep). The method of payment can vary. Depending on the program, the money can be received as a lump sum, as a line of credit, or as a monthly payment. The amount advanced under the mortgage (up to 40%, but more often 20 to 30%, of the home value) depends on the value of the home and the age and marital status of the proposed mortgagor (e.g., a younger senior will receive less than an older senior, because of the increased lifespan that is likely). In most plans, the loan and interest must be repaid only when the homeowners sell the house or die; the principal and interest are left to compound and the mortgage is fully discharged at the time of sale. 22

27 Chapter 4-Other Sources of Retirement Funds. When property values fall, the amount owing on a reverse mortgage could exceed the value of the property when sold. Even though it is possible that the loan and accumulated interest might become greater than the value of the home, neither the plan holders nor their estates will have to pay back more than the home s value. When are received they are tax-free. Thus, using funds from a reverse mortgage, rather than those from a RRSP, allows the individual to take continued advantage of those government plans (i.e., GIS, OAS) that are based on levels of income. Reverse mortgages have legal, appraisal, and closing costs to consider. If interest rates are not fixed, they float and tend to be on the high side. Obviously, a reverse mortgage can have a negative impact on the estate values of the home owner(s). Tax-Free Savings Account (TFSA) The TFSA is a registered account to which contributions can be made to a maximum of $5,000 annually. Contributions are not tax-deductible. Contributions grow on a tax-free basis and withdrawals are also tax-free. No beneficiary is named for the account. On the death of the account owner, the funds become part of his or her estate. 23

28 Chapter 5 Registered Retirement Plans A Registered Retirement Plan is one that has been registered with the Canada Revenue Agency so that tax advantages can be received by the plan owner. The plan owner does not make application directly to CRA, but when a plan is established with the institution holding the RRSP (such as a bank, trust company, insurer, or investment firm), the institution registers the plan on behalf of the individual. Registered plans include: Registered Retirement Savings Plan (RRSP); Registered Retirement Income Fund (RRIF). In addition, locked-in registered plans include: Locked-In Retirement Account (LIRA); Life Income Funds (LIF) (in all provinces except Saskatchewan); Locked-in Retirement Income Fund (LRIF) (in Newfoundland and Manitoba); Prescribed RRIF (in Saskatchewan and Manitoba). Registered Retirement Savings Plans (RRSPs) A Registered Retirement Savings Plan (RRSP), as provided by the Income Tax Act, defers tax to assist individuals in saving for their retirement years. An RRSP can help an individual attain a higher standard of living by supplementing their government or private pension with additional funds. An RRSP is available as a managed or self-directed plan. In both types of plans, the plan holder chooses from a variety of investments, though the selfdirected plan holder has options the managed plan holder does not. A managed plan is one in which the plan holder s deposit is invested in products held in trust under the plan. No further investment decisions are required by the plan holder. Managed plans offer a wide range of investment options that include Guaranteed Investment Certificates, market-linked GICs, retirement savings deposits, and mutual funds. 24

29 Chapter 5-Registered Retirement Plans. In a self-directed plan, the plan holder s assets are administered by a bank, trust company, or investment dealer. All investment decisions are made by the plan holder. Contributors to RRSPs All individuals who have eligible earned income (including non-residents with Canadian earned income) may contribute to an RRSP up to December 31 of the year in which they reach age 71. Although individuals may own as many RRSPs as desired, they may retain ownership of their plans only up to the end of the calendar year in which they turn 71. At that point, they must be cashed-out (and tax paid accordingly), converted to a RRIF or annuity, or, if locked-in, to a LIRA, LIF, LRIF, or PRIF. Contributions Contributions to an RRSP for a calendar year may be made during that specific calendar year or up to 60 days after the end of the calendar year. The contributor receives a form from the institution to which the contribution was made, which must be attached to his or her income-tax return. There are six factors that determine how much can be contributed to a RRSP: 1. The Annual Amount There is a maximum amount that can be contributed annually to an RRSP. It is the lesser of two amounts: in 2011 either $22,450 or 18% of earned income for This is typically expressed as 18% of the previous year s earned income. Correctly determining earned income is essential to the computation. Earned income for RRSP contribution limits is different from earned income for tax purposes. The fundamental difference is that earned income for tax purposes includes investment income (interest, dividends, and capital gains), whereas earned income for RRSP purposes does not include investment income. 25

30 Retirement Planning II Determining Earned Income Earned income includes: Deductions from earned income: Not included in earned income for RRSPs: gross salary (before deductions alimony paid and any taxable investment income for CPP, EI, etc.) support payments commissions deductible employment-related pension benefits expenses, such as union dues net business income rental losses retiring allowances net research grants pension adjustment severance pay royalties past service pension adjustment death benefits alimony received and any taxable support payments payments from a RRSP, RRIF, or deferred profit-sharing plan net rental income disability income from CPP 2. The Annual Contribution, Reduced by Other Pension Plan Contributions The amount that can be contributed to an RRSP is reduced by contributions made to a Registered Pension Plan (RPP) or a Deferred Profit-Sharing Plan (DPSP). This is called a pension adjustment (PA). It is the amount contributed to the RPP or DPSP for the previous year. So the pension adjustment for 2010 reduces the amount that can be contributed to your RRSP for If an employee works at a firm that begins a pension plan, the employer will make a contribution to the employee s pension plan for the years the employee worked for the employer before the pension plan was implemented. So, if you worked for seven years for the company before a pension plan was started by the company, the company would contribute seven years worth of contributions to your plan. This is called a past service pension adjustment (PSPA) and also reduces the amount of RRSP contribution. 3. The Annual Amount Increased by a Catch-up Contribution The amount of contribution room will be increased if the plan holder has failed to make the maximum RRSP contribution in any year. This amount, called the unused contribution room, is made known to the plan holder by a notification from Canada Revenue Agency annually and can be carried forward indefinitely. This is called the RRSP carry forward feature. 4. The Annual Amount Increased by Overcontributing The Income Tax Act allows plan owners a lifetime and cumulative overcontribution amount of $2,000. The $2,000 overcontribution can be made at any time; the purpose of making the contribution is to compound growth in the plan. 26

31 Chapter 5-Registered Retirement Plans. If the overcontribution exceeds $2,000, a penalty of 1% per month is charged on the excess amount. The excess above $2,000 may be withdrawn without being taxed if it is done in the year in which the client receives a Notice of Assessment for the year the excess contribution was made or in the following year. 5. The Annual Amount Reduced by a Contribution to a Spousal RRSP A legally-married or common-law spouse may contribute to an RRSP registered in the name of his or her spouse. This is called a spousal RRSP. The maximum contribution to a spousal RRSP is equal to the contributor s RRSP contribution limit minus any contribution that was made to his or her own individual RRSP. So, if the contribution limit of one spouse is $18,000 and he contributes $8,000 to the spousal RRSP, he has $10,000 left in contribution room for himself. If withdrawals are made from the spousal plan in the year of the contribution or in the two preceding years, the withdrawal is taxable to the contributor. The reason to maximize contributions and hopefully growth in a spousal plan is to benefit from the lower tax bracket of that spouse. Thus, funds are taxed at a lower rate when they are withdrawn. If both spouses are in the same tax bracket and both plans are topped-up by maximum regular contributions, there is no purpose to making spousal contributions. 6. The Annual Amount Increased by Contribution of Retiring Allowances Retiring allowances include severance pay, sick-leave credits, and court awards for wrongful dismissal (except for damages for mental anguish, humiliation, etc.) earned for each year of employment prior to Although they are included in earned income, part or all of them may be transferred tax-free to a RRSP without using up annual RRSP contribution limits. The amount that may be transferred is $2,000 for each calendar year (or part year) of service before 1996, plus $1,500 for each year of employment before 1989 for which employer contributions to his or her pension plan have not vested. There is no consideration for employment post Tax Receipts The issuers of RRSPs are required to provide plan owners with official tax receipts for contributions by March 31 of the following year. Tax receipts are to be issued for: ordinary contributions; contributions representing payments from a registered pension plan or deferred profitsharing plan that are transferred to the RRSP of the plan holder or his or her spouse; contributions representing retiring allowances. 27

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