1 Clients want to know: Where Will the Money Come From? After reading this, you should understand: The sources of retirement income The Sources of Retirement Income There are four broad sources of retirement income: 1. Personal, non-registered savings; 2. Registered savings plans; 3. Registered pension plans; 4. Government retirement pensions. Personal, Non-registered Savings As you will see in this section, contributions to registered savings plans, private pension plans, and government retirement pensions are all limited. The personal savings plan will be the form in which people save funds in excess of these plans since there is no limit to the amount that can be saved and invested. Guaranteed Investment Certificates (GICs) are a popular savings vehicle for retirement and during retirement, due to their low risk. Registered Pension Plans (RPPs) A registered pension plan is a plan set up by an employer to provide a retirement income for its employees. + FILE See File 50 for an illustration of a GIC in practice. Life insurance with cash value, segregated funds, and annuities are investments to which funds can be directed that provide for the tax-deferred growth and can supplement retirement income. Life Insurance Policy Cash Surrender Values as a Source of Income It is not improbable to find a person with a life policy struggling to find ways to supplement retirement income. A policy with a cash value that is, whole life or universal life can help to provide the policy owner or his or her spouse with an income during retirement. + FILE See File 51 for an illustration of life policies used for retirement purposes. Copyright 2011 Oliver Publishing Inc. All rights reserved. 323
2 LLQP Options include: On the death of the life insured, using the face amount of the policy to buy a life annuity for the survivor. A life annuity will provide an income, until death. The cash surrender value (CSV) could be taken, and the proceeds used to buy a life annuity. A policy loan for 90% of the CSV could be taken and, although the death benefit would be reduced by the amount of the loan, a beneficiary would receive some funds at settlement, perhaps to assist with last expenses. If a universal life policy is in place, a cash withdrawal could be made, which, while reducing the amount of death benefit, does not require the policy to be sacrificed. + FILE See File 52 for on use of life insurance for final expenses. While each option has benefits and drawbacks, they are useful to bear in mind should the need for retirement income take precedence over estate-planning uses (such as the payment of capital-gains tax). Personal savings can also include the equity that has been built in a home via mortgage payments. Such equity can be accessed by a reverse mortgage: an option that is beyond the scope of the LLQP course. Which of the following statements is correct? A B C D Policy CSVs can create an income stream via the purchase of an annuity. A variable annuity will create a stable income. Insurance policy loans exceed 90% of CSVs when they are used to purchase an annuity. There are no drawbacks to utilizing accumulated cash surrender value as retirement income. Tax-Free Savings Accounts (TFSA) Earlier in this book we referred to the new savings plan, the Tax-Free Savings Account, and its use to fund the costs of higher education. The TFSA will also be very useful in the context of planning for retirement income. 324 Copyright 2011 Oliver Publishing Inc. All rights reserved.
3 Sources of Income Like RRSPs, the TFSA has a limit to the amount that can be contributed; in 2010 and 2011 the amount will be $5,000. That figure will be indexed for future years at the inflation rate, in $500 increments. Unused contribution room can be carried forward, as with an RRSP. The investments in the TFSA can be held in the same investments as an RRSP. On the death of the plan owner, plan assets can be transferred to the TFSA of the owner s spouse or common-law partner. Unlike RRSPs, the TFSA contribution is not tax-deductible, and withdrawals are not taxed. The TSFA provides a valuable opportunity for tax-free investment growth, while providing retirees with a source of income that will not affect their OAS benefit (because withdrawals are not taxable income). Withdrawals from the TFSA are unlimited. Comparison of RRSPs/RRIFs and TFSAs RRSPs/RRIFs TFSAs Contribution limit $22,450 $5,000 (2011) Tax deductibility of yes no contributions Tax on withdrawals yes no Tax on investment growth while in the account no no Registered Savings Plans A registered savings plan is initiated by the client. There is no requirement to have such a plan. It is simply an excellent idea to have one to take advantage of the tax savings that such a plan provides. Registered Retirement Savings Plans A Registered Retirement Savings Plan (RRSP), as provided for by the Income Tax Act, is a plan designed to help people save for their retirement. The plan permits individuals to receive a tax deduction for their contributions to the RRSP, and then defers tax on growth within the plan until withdrawals are made. A RRSP can help an individual attain a higher standard of living during retirement by supplementing their government or private pension with additional funds. Copyright 2011 Oliver Publishing Inc. All rights reserved. 325
4 LLQP 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 not available to the managed plan holder. A managed plan is one in which the plan holder s contribution is invested in products held in trust under the plan. Managed plans offer a wide range of investment options, including Guaranteed Investment Certificates (GICs), indexlinked GICs, retirement savings deposits, mutual funds, and segregated funds. In a self-directed plan, also called a self-administered RRSP, the plan holder s contributions are administered by a bank, trust company, or investment dealer. All investment decisions are made by the plan holder. Investment options, such as some stocks, are available to the self-directed plan holder that are not available to the managed plan holder. Qualified investments for self-directed RRSPs include: Money on deposit in banks or similar institutions; Bonds, debentures, and similar obligations guaranteed by the government of Canada, a province, municipality, or crown corporation (including Canada Savings Bond issues); Shares and debt obligations of Canadian public companies; Shares of foreign public corporations listed on a stock exchange outside Canada; GICs issued by a Canadian trust company; Certain annuities issued by Canadian companies; Shares of a utility company can be purchased within a self-directed RRSP. In a managed plan, such shares would be acquired through the holdings of a mutual fund. 326 Copyright 2011 Oliver Publishing Inc. All rights reserved.
5 Sources of Income Units of a mutual-trust or an insurance-company pooled fund; Rights or warrants related to securities that qualify for a RRSP; The purchase of call options on Canadian equities or Canadian debt instruments on a recognized Canadian exchange and the writing of covered calls on Canadian equities on a recognized Canadian exchange; A mortgage, or interest in a mortgage, or a pool of mortgages secured by real property located in Canada. Interest in Mortgage-Backed Securities (MBS) (i.e., pools of first mortgages on Canadian residential properties guaranteed by Canada Mortgage and Housing Corporation) and shares in most Canadian mortgage investment companies; Shares, bonds, debentures, or similar obligations issued by certain cooperatives or credit unions, and shares of certain investment corporations; Certain life insurance policies; Bankers acceptances; Limited partnership units listed on a Canadian stock exchange; Capital stock of a small business corporation (SBC), qualified venture capital corporation, or specified cooperative corporation; Gold and silver bullion of acceptable purity. Investments that do not qualify for self-directed RRSPs include: Precious metal bars and coins with fair market value above their stated value as legal tender; Shares and debt obligations of private corporations subject to some conditions being met; Commodity futures contracts; Works of art, jewellery, or antiques. Which of the following do not qualify as investments for self-administered RRSPs? A B C D Gold, and silver bullion Diamonds, emeralds, and rubies Certain life insurance policies Mortgage-backed securities Copyright 2011 Oliver Publishing Inc. All rights reserved. 327
6 LLQP Making Contributions to a Registered Plan 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, the plan is said to have matured, and it must be cashed out (and tax paid accordingly), or converted to a Registered Retirement Income Fund (RRIF) or annuity. Each year, the Canada Revenue Agency mails taxpayers a statement that confirms their maximum RRSP contribution limit for that year. 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, unless the contributor has turned 71 that year. In that case, the contributor must contribute by year-end. The issuers of RRSPs are required to provide plan owners with official tax receipts for their contributions by March 31 of the following year. These are attached to his or her income-tax return. Retirement funds are locked-in to provide the employee with a future retirement income. Contributing to an RRSP There are six factors that determine how much can be contributed to a RRSP: 1. The Annual Contribution Limits There is a maximum amount that can be contributed annually to an RRSP. It is the lesser of two amounts: the dollar amount limit for the year, as specified by the Canada Revenue Agency ($22,450 in 2011) or 18% of the previous year s earned income. 328 Copyright 2011 Oliver Publishing Inc. All rights reserved.
7 Sources of Income The dollar amount limit of contribution increases annually. Determining earned income correctly is essential to an accurate computation of a person s contribution limit. Earned income for RRSP contributions 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. Which of the following are not considered earned income for RRSP calculation purposes? A B C D Payments from a DPSP Stock dividends Deferred annuity income All of the above 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, professional association charges 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 Limit, Reduced by Contributions to Other Pension Plans 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). These are the types of pensions provided by employers. The contribution to these plans is called a pension adjustment (PA). It is the amount contributed to the RPP or DPSP for the previous year. So, the amount that can be contributed to your RRSP for 2011 is reduced by your pension adjustment for Copyright 2011 Oliver Publishing Inc. All rights reserved. 329
8 LLQP Sometimes an employee may be eligible to make optional additional contribution to his pension plan for years that he worked earlier. This kind of contribution is possible only in defined benefit plans and usually comes about under the following circumstances: a) The employer starts a new pension plan. To benefit old employees the plan may permit voluntary contributions for past years of service in the company. b) If the plan benefit is increased from, say, 1.5% to 2%, the plan may allow for voluntary contributions to reflect the benefit retroactively. Such voluntary contribution to a defined benefit plan when permissible is called a past service pension adjustment (PSPA), and it also reduces the amount of RRSP contribution. A pension adjustment is...? A B C D A clawback tax A reduction in CPP benefits The accrued benefits in CPP The amount deducted when calculating allowable RRSP contribution room for the subsequent tax year. 3. The Annual Contribution Limit 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 the Canada Revenue Agency annually and can be carried forward indefinitely. This is called the RRSP carry-forward feature. The phrase carry forward means? A B C D Part of the multiplication process The balance of a taxpayer s Alternative Minimum Tax credit A brutal piggyback exercise commonly practiced in karate class The act of allocating unused RRSP contribution to a future tax year 4. Overcontribution to RRSP The Income Tax Act allows RRSP plan owners a cumulative overcontribution amount of $2,000. The $2,000 overcontribution can be made at any time; A penalty tax of 1% per month is assessed on the cumulative excess amount (CEA) in the Registered Retirement Savings Plans (RRSPs) plan until the excess is withdrawn. 330 Copyright 2011 Oliver Publishing Inc. All rights reserved.
9 Sources of Income The CEA is calculated as follows: Total undeducted RRSP contributions after 1990, less individual s unused RRSP contribution room + $2,000 (lifetime overcontribution limit) 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 Contribution Limit 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 RRSP. So, if the contribution limit of one spouse is $20,000, and he contributes $5,000 to the spousal RRSP, he has $15,000 left in contribution room for himself. + FILE See file 53 for an illustration of a spousal RRSP. If withdrawals are made from the spousal plan in the year of the contribution or the two full years following, the withdrawal is taxable to the contributor. Until several years ago, the reason to maximize contributions and hopefully growth in a spousal plan was to benefit from the lower tax bracket of that spouse when funds were withdrawn. However, since pension-splitting of RRSPs, RRIFs, and RPPs came into effect, the need to use spousal RRSP contributions for income-splitting has been diminished. A spousal plan can be used to split income more than 50% if the couple desires, by contributions to a spousal RRSP. A spousal plan is still useful if one spouse is older than 71 and the other younger, because contributions can be continued to be paid into the younger spouse s plan until the plan matures. A spousal RRSP uses contribution room of the contributing spouse. However, withdrawals may be taxed at a much lower rate if the spouse receiving the contribution has no other sources of retirement income. Copyright 2011 Oliver Publishing Inc. All rights reserved. 331
10 LLQP Which of the following reasons illustrate why a spousal RRSP is a great retirementplanning concept? A B C D It allows the contributor spouse to reduce tax and access his cash immediately. Spousal RRSPs are used in divorce settlements, often to the advantage of the contributor spouse. The lower-income spouse can cash in the contributed amount, but must pay tax on the redemption proceeds. The lower-income spouse will pay less tax on withdrawals than the contributing higher-income spouse. 6. The Annual Contribution Limit Increased by 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 Summary of Contributions to an RRSP Decreased by Annual Contribution Limit Increased by $22,450* or 18% of earned income Contributions to other Catch-up contribution pension plans Contributions to a spousal plan * For 2011 One-time overcontribution Contribution of retiring allowance 332 Copyright 2011 Oliver Publishing Inc. All rights reserved.
11 Sources of Income Calculate Your RRSP Contribution Limit Practice this calculation using your own earned income for the last taxation year. To complete the calculation, even though the Pension Adjustment and Past Service Pension Adjustment may not be applicable to you, or you may not have unused contribution room, put $1,000 in each space. 1. Taxation year RRSP $ Limit: $ 2. Calculate earned income for the PREVIOUS year: $ x.18 = $ 3. Lesser of 1 or 2: $ 4. Minus the Pension Adjustment (PA) for the PREVIOUS year: $ 5. Minus the Past Service Pension Adjustment (PSPA) for the CURRENT year: $ 6. Equals current year s RRSP contribution limit: $ 7. Plus any unused RRSP contribution room from all previous years: $ 8. Total RRSP contribution limit: $ 9. Plus $2,000 allowable overcontribution for those 19 years and older (if not already claimed) $ Withdrawals from an RRSP There are three ways in which funds may be removed from a RRSP: As cash On maturity, when they are: - Transferred to an annuity; - Transferred to a Registered Retirement Income Fund (RRIF); - Transferred to another RRSP, as long as this is done prior to December 31 of the year in which the plan holder turns 71 years of age. At age 71, the RRSP must be converted to one of the above options; - On death. Copyright 2011 Oliver Publishing Inc. All rights reserved. 333
12 LLQP Cash Withdrawal Funds may be withdrawn from an RRSP at any time. When funds are withdrawn, the financial institution is required to deduct a withholding tax on the amount withdrawn. The gross amount withdrawn (including the amount of the withholding tax) is added to the plan holder s taxable income for that tax year and is taxed at the individual s marginal tax rate (MTR). Double taxation is avoided since the plan holder gets credit for the tax that was withheld when the withdrawal was originally made. The withholding tax for residents of Canada is as follows: Withdrawals All provinces except Quebec Quebec* up to $5,000 10% 21% $5,001 to $15,000 20% 26% $15, % 31% *includes 16% provincial tax On Maturity All funds must be either withdrawn or transferred from the RRSP by the end of the calendar year in which the plan owner reaches the age of 71. Options for transferring the funds and continuing to defer tax include Registered Retirement Income Funds (RRIFs) and annuities. At the end of the year when we turn 71 we want to roll over the value of the plans into Registered Retirement Income Funds. If we don t do that, the plans will be cashed out and we will be taxed on their value. 334 Copyright 2011 Oliver Publishing Inc. All rights reserved.
13 Sources of Income On Death An RRSP holder can designate a beneficiary of the plan who can continue to enjoy the advantage of deferred tax on the funds. These beneficiaries include: - His or her spouse; - Dependent children or grandchildren. Spouse The funds can be transferred tax-free (called a rollover) to the spouse s own RRSP or RRIF. The spouse can also avoid paying tax on the transferred funds if they are used to acquire an annuity and pay taxes at the spouse s marginal tax rates on withdrawals. Dependent Children or Grandchildren If transferred to a financially dependent child or grandchild, the funds will be included in the income of the child or grandchild and taxed when received, or the amount can be transferred if they are used to buy a term annuity to age 18. The annuity must be purchased in the year the funds are received or within 60 days of year-end. Payments must begin no later than one year after the annuity has been purchased, and tax is paid on the annuity payments, when received by the child. A child or children with physical or mental infirmity can transfer the funds to the child s RRSP or life annuity. If any other beneficiary is named, the full value of the plan will be included in the income of the deceased, then the net funds are paid to the beneficiary. What does the term rollover mean for RRSP annuitants? A The tax-free transfer of the RRSP proceeds to a designated spouse on the death of the annuitant B A bad night s sleep C A transfer of RRSP proceeds to a dependent child over age 18 D The conversion of an annuitant s RRIF back to an RRSP The Pros and Cons of RRSPs for Retirement Savings Advantages of an RRSP: Tax-deductible contributions within allowable limits. Thus, a person can reduce his or her income by making a RRSP contribution that will, in turn, reduce the amount of tax owed. When income is withdrawn from the RRSP, the plan holder is likely to be in a lower tax bracket and, so, less tax is paid. Copyright 2011 Oliver Publishing Inc. All rights reserved. 335
14 LLQP Tax-deferred compounding of interest, dividends, and capital gains in the plan. This tax-deferred compounding allows the savings invested in the RRSP to grow much faster than they would if invested where they could not grow tax-deferred. However, the entire sum withdrawn in the year is taxed as income. There is no tax-preferential treatment for dividends and capital gains received in an RRSP account. The advantage is tax deferral. Control over investments. RRSPs allow the plan holder to retain control over the management of his or her investments and they offer a wide range of investment options. Pre-authorized contribution. PACs allow individuals to make monthly RRSP contributions in regular, easy-to-manage instalments throughout the year. The carrying forward of unused contribution room. Plan holders can carry forward any unused contribution room from prior years. The plan is unaffected by a job transfer or job loss. It can provide money for an early retirement or a sabbatical from work. It can provide for retirement income-splitting by a spousal contribution, thereby reducing the effective tax rate on the combined incomes. Interest charged on a loan for an RRSP contribution is not tax-deductible, but the larger the RRSP contribution the more funds that can grow on a tax-deferred basis. 336 Copyright 2011 Oliver Publishing Inc. All rights reserved.
15 Sources of Income Choose the correct investment benefit of an RRSP from the following. A B C D Investment growth inside an RRSP is not taxed. Compounded investment earnings are mixed with original capital deposits and are taxed as regular income. Investment-growth compounds on a tax-deferred basis, as long as the earnings remain in the plan. investment income is taxed at the annuitant s MTR, regardless as to the type of investment earnings. Disadvantages of Owning an RRSP When funds are withdrawn, the plan holder pays income tax on all funds as if they were interest. There is no preferential tax rate for dividends earned or capital gains or losses. A graduated withholding tax is deducted from withdrawals. At death, payments out of the RRSP to the plan holder s estate are taxed as income of the deceased, unless they are directed to a spouse or a financially dependent child or grandchild of the deceased plan holder. RRSPs are not creditor-proof, and may be seized by creditors, unless the funds are placed in an IVIC (segregated fund). Non-retirement Uses of RRSPs In addition to their use for retirement savings, RRSPs can also be used for: The Home Buyers Plan: The Lifelong Learning Plan. + FILE See file 54 for the details on the Home Buyers Plan and Lifelong Learning Plan. Home Buyer s Plan (HBP) Up until 2009, the Home Buyers Plan allowed a RRSP plan holder to withdraw up to $20,000 from his or her RRSP to buy or build a qualifying home if neither spouse has been a homeowner in the year of such withdrawal or the previous four calendar years. In 2009, the amount of withdrawal increased to $25,000. An RRSP owner can now withdraw up to $25,000 to buy or build a qualifying home if he or she has not been a homeowner for the preceding four years. The withdrawal must be repaid within 15 years. Copyright 2011 Oliver Publishing Inc. All rights reserved. 337
16 LLQP Lifelong Learning Plan (LLP) If the taxpayer or his/her spouse is pursuing full-time studies in a recognized educational institution, a withdrawal of up to $20,000 may be made from an RRSP under the LLP over a period of four years ($10,000 maximum in any given year. It cannot be used to pay for a child. A Registered Education Savings Plan (RESP) is used to save for the educational expenses for a child. The Lifelong Learning Plan gives an adult with an RRSP a way to access funds for higher education. Are RRSP-funded HBPs and LLPs a good thing? A B C D Yes, they offer options to having to keep your money tucked away in an RRSP. Yes, such plans help put RRSP capital to work. Yes, HBPs and LLPs allow RRSP owners the opportunity to diversify their RRSP capital and generate higher income through further education and better job prospects. No, because they reduce the amounts available for retirement. The Agent and the RRSP When a client opens a registered account with an insurer, the agent has a responsibility to the client to ensure the funds are invested with the objectives of the client in mind and according to the client s characteristics as an investor. Based on suitability information, the agent must determine whether a managed or self-directed plan is best for the client. A client who has the interest, time, and desire to be an active investor and who will monitor investments on an ongoing basis will be a good candidate for a self-directed plan. An investor who wants to buy and sell shares must have a self-directed RRSP. 338 Copyright 2011 Oliver Publishing Inc. All rights reserved.
17 Sources of Income The time horizon of the investment must be carefully considered in a RRSP. The RRSP must be terminated before the end of the year in which the plan holder turns 71. For this same reason, liquidity of the investment may be an important issue: it will be essential to easily and quickly liquidate the contents of the RRSP if the investor plans to cash out the plan at its maturity date. Finally, risk tolerance will be a very important factor in selecting appropriate investments for the RRSP. Saving for retirement is a serious savings goal that requires careful long-term thinking to assure that dreams will be met without sacrifices having to be made. Agents have a fiduciary duty to advise clients fairly and accurately about sources of retirement income and the role life insurance can play. What is the most important job of an insurance agent? A To succeed to the President s Roundtable for exceptional sales volumes B To find a balance between professional and personal ethics C To achieve personal financial freedom by age 55 D To insure that the financial goals and interests of his or her clients are met to the best of his or her ability. Registered Retirement Income Funds (RRIFs) An RRSP matures on December 31 of the year in which the plan holder turns 71. The money in the RRSP must be moved out of the plan by that date. One of the options a plan holder has is to transfer RRSP funds into a Registered Retirement Income Fund (RRIF). A RRIF is an account to which RRSPs can be transferred without incurring tax at the time of transfer, and continues tax deferral on the transferred funds. Copyright 2011 Oliver Publishing Inc. All rights reserved. 339
18 LLQP An individual may own as many RRIFs as he or she likes, and purchase them at any age, up to the end of the calendar year in which he or she turns 71. The earnings on the investments in the RRIF are tax-sheltered. Just as with RRSPs, RRIFs are available as managed and self-directed plans. Why is age 71 so important to Canadians? A B C D Death prior to age 71 is considered premature. Women often live well beyond this age, and special retirement planning must be undertaken to insure these exceptional individuals can survive financially. It is the age at which all individual registered plan owners must convert their retirement savings to retirement income. Canadian military personnel can no longer defer a lump sum retirement benefit from the federal government. RRIF Withdrawals A RRIF has an annual minimum withdrawal requirement. Withdrawals are reported as income annually. The minimum withdrawal is determined by the age of the plan holder or his or her spouse s age, the date on which the RRIF was established, and other factors, such as whether the plan has been changed since it was first established. The Canada Revenue Agency (CRA) calculates minimum withdrawals as a percentage of the value of the plan. When withdrawals are made in excess of the minimum, the same graduated withholding tax is applied as to RRSP withdrawals. The withdrawals must still be included in annual income, but an allowance is made for the amount withheld. Because amounts above the minimum can be taken, there is more flexibility in a RRIF than an annuity which provides a set benefit. (Please note that there is no maximum limit on the amount that can be withdrawn from an RRIF. The owner of the RRIF may choose to withdraw the entire balance in his/her RRIF and close the account.) The minimum withdrawal amount is based on: Pre-March 1986 : Used if the plan was established before March 1986 and has not been changed in any way since that date. In addition, there are restrictions for its use if the plan holds an annuity contract. + FILE See file 55 for the details on a RRIF withdrawal. Qualifying RRIFs : Used if the plan was established before 1986, but has subsequently been changed, or established between 1986 and before 1993, or established after 1993 when there has been a transfer from another Qualifying RRIF. All other RRIFs : Covers all other possibilities. 340 Copyright 2011 Oliver Publishing Inc. All rights reserved.
19 Sources of Income The CRA table applies from age 71 of the RRIF plan holder or his or her spouse onward. However, if the plan holder or spouse is 70 or younger, the minimum withdrawal is calculated as: 1 (90 minus the age of the plan holder or spouse) multiplied by the value of the RRIF. For example, if the plan holder who is 70 has a RRIF valued at $100,000, the minimum withdrawal will be: 1 (90 70) = 0.05 x $100,000 = $5,000. RRIF Proceeds on Death When a RRIF plan holder dies, he or she is considered to have received immediately before death an amount equal to the fair market value (FMV) of all property held in the RRIF at the time of death. This amount will be included in the terminal tax return. If the spouse of the plan holder is named as successor annuitant, the RRIF continues, the spouse becomes the annuitant, and income the spouse receives is taxed in the hands of the spouse. When a spouse is named the sole beneficiary of a RRIF, the funds in the RRIF can be transferred to the spouse s RRSP, if he or she is younger than 71, to an RRIF, or into a life annuity. Tax is not paid at the time of transfer but when payments are received. If the spouse is named the sole beneficiary, the funds within the RRIF can be transferred to an RRSP if the spouse is younger than 71, to an RRIF, or can be used to buy an annuity. Tax will be paid when funds are received by the spouse as income. A financially dependent child or grandchild of the annuitant who is dependent due to physical or mental infirmity is considered a qualified beneficiary and can defer paying tax on any transfer of the RRIF if it is transferred to a RRSP, RRIF, Copyright 2011 Oliver Publishing Inc. All rights reserved. 341
20 LLQP or qualified annuity. If the child or grandchild is not physically or mentally infirm, but is dependent on the annuitant, the RRIF can be transferred to an annuity that makes payments until the child or grandchild is 18. The child will be taxed on the payments received. + FILE See File 56 for transfer of a RRIF on death. Transfer of RRIF on Death of Plan Holder (annuitant) RRIF can be paid to RRSP RRIF Annuity annuitant s: Spouse or common-law partner * Dependent child or grandchild due to physical or mental infirmity Financially dependent child or grandchild *Spouse or common-law partner must be less than 71 years of age. A RRIF provides greater flexibility than an annuity. If the RRIF plan holder wants more funds in a year to take a trip, then the funds needed can be easily withdrawn. A penalty is charged when withdrawals are made from an annuity. Do the proceeds of a RRIF have to be paid to the deceased annuitant s estate? A Yes, when no alternative beneficiary has been named on the plan. B No, they are always rolled over to the spouse. C Yes, if the deceased annuitant has a dependent less than age 18. D All of the above Registered Pension Plans Private pensions are those pensions established by employers for the benefit of their employees. These pension plans are called Registered Pension Plans (RPPs). Not all employees have a pension plan from their employer. An employer-sponsored RPP can take the form of a: - Defined plan; - Deferred profit-sharing plan (DPSP); - Group Retirement Savings Plan (GRSP). 342 Copyright 2011 Oliver Publishing Inc. All rights reserved.
21 Sources of Income A registered pension plan provides a pension to the plan member for the duration of his or her life. We have suggested retirement planning begin at an age when other financial pressures have lessened, for most people in their mid to late forties. To answer the question How much will I have to live on from my pension? you will need to turn to the pension benefit statement that registered pension plan members receive annually. It will typically show the amount to be received on what is termed the Normal Retirement Date. However, the plan member should recognize the effect that inflation will have on the amount to be received. About 20% of the defined benefit pension plans in Canada provide an automatic Cost of Living Adjustment (COLA) to help offset the effect of inflation. The COLA is based on the Consumer Price Index (CPI) published by Statistics Canada that measures the increase in the cost of living. A company that sponsors a pension plan without a COLA may recognize that the pension it is providing is being diminished by inflation and will increase pensions accordingly. These increases cannot be planned for. Defined Plans A defined RPP plan is either a: Defined benefit plan; or a Defined contribution plan (also called a money purchase plan). Defined Benefit Plan An employee with a defined benefit plan knows exactly how much he or she is going to pay for the pension and how much he or she will receive when retired. The employer, however, does not know precisely how much it is required to contribute since the amount of capital needed to provide the pension will be affected by interest rates during the period of accumulation. Copyright 2011 Oliver Publishing Inc. All rights reserved. 343
22 LLQP On retirement, the funds from a defined benefit plan can be used to purchase a life annuity, or they can be transferred to a locked-in plan. Defined benefit plan pensions are determined according to the type of plan the employer sponsors. 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. These credits are pre-set and are expressed as a percentage of employment income for that year. 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 income-earning 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. A fixed amount will be received regardless of income. N.B. Final average earnings and best earnings plans usually produce larger pensions. Pension Plan Benefits: Best Bet for Highest Pension $$$$ Highest benefit best earnings plan $$$ next highest final average plan $$ then career average plan $ lowest of the four plans flat benefit plan 344 Copyright 2011 Oliver Publishing Inc. All rights reserved. Lowest benefit
23 Sources of Income The ability to make retirement plans is enhanced by the defined benefit plan form of pension in which the pensioner knows exactly how much money will be received as a pension. Defined Benefit Plan Past Service Benefits Sometimes an employee may be eligible to make optional additional contribution to his pension plan for years that he worked earlier. This kind of contribution is possible only in defined benefit plans and may come about usually under the following circumstances: a) The employer starts a new pension plan. To benefit old employees the plan may permit voluntary contributions for past years of service in the company; b) If the plan benefit is increased from, say, 1.5% to 2%, the plan may allow for voluntary contributions to reflect the benefit retroactively. Such voluntary contribution to a defined benefit plan when permissible is called a past service pension adjustment (PSPA) and it also reduces the amount of RRSP contribution that a person can make in the same year the past service contribution is made. Past service means? A B C D Irretrievable pension credits Special EI benefits for recently retired employees Hours worked that are eligible for EI benefits and/or employer pension payments Pensions for employees who worked for their employer prior to the implementation of an employer-sponsored pension plan. Defined Benefit Plan Management Defined benefit pension plans give rise to substantial potential liabilities for employers; employers are obligated to provide adequate funding, since they must provide promised future benefits. Many companies use the services of insurance companies to manage pension plans. The employer has the choice of three methods to fund a pension plan. All three options are designed to transfer some of the administration hassles and liabilities to the insurance company. Copyright 2011 Oliver Publishing Inc. All rights reserved. 345
24 LLQP These plans are: Group annuity contracts; Deposit administration contracts; Segregated fund contracts. Group annuity contracts: These limit the employer s responsibilities to enrolling the employees, deducting their contributions from wages, and paying these and the employer s contribution to the insurance company on a periodic basis (usually monthly). Deposit administration contracts: Instead of making regular payments (e.g., monthly), the employer deposits enough money with the insurance company to buy the promised benefits. If contributions have been underestimated, then shortages have to be made up by extra deposits. What is the major problem with defined benefit plans? A They are expensive to operate. B They are very complicated for plan administrators. C The employer is on the hook for any future pension funding shortfall. D All of the above Segregated fund contracts: These contracts are similar to a deposit administration plan, except that they permit pension funds to be invested in potentially high-yield securities, such as bonds, common stock, and mortgages. Segregated-fund contracts seek to optimize the rate of return on pension funds to the employer in place of traditional performance guarantees. If the investments are successful, the final pension amounts are likely to be higher than under group annuity and deposit administration contracts, where the insurance companies invest the premiums and deposits in extremely low- or non-risk securities. What investment vehicle(s) can help offset some of the problems faced by defined benefit plans today? A Precious metals bullion B Fixed-income securities C GICs D Segregated funds Defined Benefit Plan Maximum Benefit The maximum yearly pension that can be provided by a defined benefit plan is the lesser of: $2,552 in 2011 multiplied by the number of years of pensionable service, or 346 Copyright 2011 Oliver Publishing Inc. All rights reserved.
25 Sources of Income 2% per year of pensionable service multiplied by the average of best consecutive years of remuneration. Typically, three or five consecutive years is the period used. After only two years of contributing to a pension plan, the plan member s contributions are vested, meaning that they belong to the member irrevocably. However, the funds will be locked in until retirement. Defined Contribution Plans A defined contribution plan, also called a money purchase plan, pools contributions of the employer and the employee to provide the pension. The employer and the employee each know the cost of such a plan, but the value of the pension itself is not known, because interest rates and investment earnings will have an impact on the total value of the pool of funds that are contributed. N.B. An employee with a defined contribution plan does not know how much he or she will receive as a pension. The contribution limit to a defined contribution plan (DCP) or money purchase plan (MPP) is similar to the contribution limit for a Registered Retirement Savings Plan: 18% of a year s earned income. The key difference is that the RRSP contribution limit is based on 18% of an individual s previous year s salary. The contribution limit for a company s defined contribution plan is based on 18% of the current year s salary. Thus, the contribution limits for 2010 were $22,450 for a DCP and $22,000 for an RRSP. In 2011, the limit for a DCP is $22,970 and for a RRSP is $22,450. An employee with a defined contribution plan has the same options on retirement as one with a defined benefit plan: the funds can be used to purchase a life annuity, or can be transferred to a Locked-in Retirement Account (LIRA) or a Life Income Fund (LIF). Why are employers moving away from defined benefit plans to defined contribution plans? They are: Copyright 2011 Oliver Publishing Inc. All rights reserved. 347
26 LLQP A B C D Cheaper to operate Less complicated for plan administrators Do not hold employers responsible for any pension funding shortfall All of the above Plan Funding The initial funding of a pension plan is based only on estimates, since future costs of the plan will change as the plan matures and employees begin to qualify for pension benefits. However, pension costs are traditionally calculated as shown in the following formula. The Calculation of Pension Costs benefit + administrative interest earnings = plan cost costs costs of the plan Regulations for Registered Pension Plans Provincial legislation ensures that pension plans are sufficiently funded, that employees receive their benefits, and that vested pension benefits are protected. The legislation covers: Pension eligibility; Vesting; Locking-in; Portability of pensions; Survivor s benefits; Inflation indexing. YMPE The year s maximum pensionable earnings is the amount of income above which contributions to the Canada Pension Plan are not made. Eligibility: The federal and provincial governments have specific requirements for eligibility for plan membership. Typically, 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. Vesting: The entitlement of an employee to retain the contributions of an employer when the employee terminates is known as vesting. The minimum period in which vesting can occur is two years. Locking-in: As we have seen, locking-in occurs when pension contributions are deposited to a Locked-in Retirement Account (LIRA), or Life Income Fund (LIF). Locking-in was created to prevent access to the funds prior to retirement. 348 Copyright 2011 Oliver Publishing Inc. All rights reserved.
27 Sources of Income Locked-in funds must begin to be brought into the income of a retired employee no later than the year following the calendar year in which the employee turns 71, or, if rolled into another registered plan, the plan must make minimum income payments. Locked-in funds represent: A B C D Contributions made to an RPP An RRSP that has not been transferred to a Registered Retirement Income Fund Contributions made to a Registered Retirement Income Fund that have not yet vested Funds in an RRSP that cannot be withdrawn until retirement Portability of Pensions: An employee with vested contributions in a RPP who changes employment is entitled to transfer these funds to a LIRA, 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. Survivor s benefits: Most plans provide members with a number of options regarding the payment of their pension after their death. They 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. 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. A key benefit of a registered pension plan is the payment to the spouse of at least 50% of the pension if the pensioner predeceases the spouse. Inflation indexing: Defined benefit and defined contribution plans are adjusted for inflation in accordance with increases in the Consumer Price Index (CPI). An RPP member with vested contributions can: A B Transfer his plan value to his or her new employer s RPP. Transfer his or her funds directly to a LIRA or to an insurance company annuity. Copyright 2011 Oliver Publishing Inc. All rights reserved. 349
28 LLQP C D Elect to keep the funds with the original employer. All of the above Vesting Vesting is the right of an employee to keep an employer s contributions to a registered pension plan. Typically, this right exists after two years of employment. Locked-in Retirement Accounts (LIRAs) or Locked-in RRSPs An individual who is enrolled in a registered pension plan with his or her employer has the right to keep the contributions the employer has made to the plan after the employee has worked for two years or more for the employer and changes jobs. This is called vesting and the funds themselves are called lockedin. Legislation prohibits these people from receiving their pension benefits in the form of cash until retirement. Locked-in funds can remain with an employer even if the employee changes jobs, or the employee can transfer the funds as long as they remain locked-in. 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). Locked-in RRSPs may hold the same types of investments as regular RRSPs and can be managed or self-directed. A Locked-in Retirement Account (LIRA) is another name for a Locked-in RRSP. Pension benefits may be transferred from an employer s plan when the employee leaves the company prior to the age of retirement to the LIRA. A LIRA generally restricts the withdrawal of funds, just as the original pension plan would do. On retirement, the funds in a LIRA continue to be locked-in and, by the end of the year in which the plan owner turns 71, the LIRA funds must be used to purchase a life annuity or transferred to a Life Income Fund, Prescribed Retirement Income Fund, or Locked-in Retirement Income Fund. Funds in a LIRA can be unlocked on specific occasions: When there is serious financial hardship; When there is shortened life expectancy; In cases of non-residency; 350 Copyright 2011 Oliver Publishing Inc. All rights reserved.
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