If you need to save more money in retirement than the maximum allowed by an RRSP, you may want to consider an Individual Pension Plan, a tax efficient way to increase your savings and ease the transfer of wealth to the next generation. Kim Parlee discusses the pros and cons with Chris Gandhu, a High Net Worth Planner with TD Wealth.
- We've all heard RSPs are a tax-efficient way to save for retirement, but what happens if you're a small business owner who needs or wants to save more than your RSP will actually let you do? Individual pension plans, IPPs, are one of the answers, and they're are also a great method for making sure that your kids and family can have that wealth passed on to them too. Here to give us the scoop on how they work and what you need to watch for, Chris Gandhu. He's a High Net Worth Planner at TD Wealth. It is great to see you.
- Thank you.
- Let's start with an IPP. I mean, why would you need one if you have an RSP? How does it work?
- Right. So an IPP is a defined benefit pension plan. The difference from an RSP is that this pension plan is managed by your company, and the company is the one making the contributions. And compared to an RSP, there is significantly higher contribution limits in an IPP. So that's one benefit is that the company gets the deductions, and you can put more money into the IPP.
The second thing is an IPP, because it's a tax-deferred account, Kim, any expenses related to an IPP are not tax deductible to you. So if you're paying somebody to manage your money, that fee is not tax deductible to you. And IPP that's inside a company, any expenses related to that or the investment management fees are deductible to the company. And the final win can be that at retirement, IPP has more flexibility than an RSP.
- Now, it does sound fantastic for a lot of people, but it's not for everybody. So who can qualify for this specifically?
- Right. First you need a corporation. This is a company-sponsored pension plan, so you need a company that has to be-- and you have to be paying yourself through this company as a salaried employee, so you have to earn the right kind of income. If you remunerate yourself by dividends or any other means, the IPP won't work. And there's other criteria, another main one being that you have to be a connected employee, which means you have to be a employee and a shareholder of the company. So there's a few checkboxes to go through.
- So things like if you're a small business owner, but you have to be an owner being the keyword there. But this could be for, doctors, dentists, and medical-- it could be even lawyers would be something that can look at it as well.
- Exactly. So the incorporated professionals, the IPP works well for them, or the true small business owners, entrepreneurs out there.
- OK. Let's talk about some numbers. How much more funding are we talking about? What would be available?
- Right. That actually depends on age. So RSPs are easy to understand. The maximum contribution room is always 18% of the earned income. It doesn't matter how old you are. IPPs, the contribution rule varies based on age and has an upward slope. So the younger you are, the less the contribution room in an IPP.
And it's around age 39, 40 when we have that RSP-IPP crossover. So if you're younger than 40, it makes sense to top up your RSP all the time. If you're older than 40, you want to look at an IPP if you're already topping up your RSP. So if you have extra money, you have maximized your RSP, what else is out there? Then the IPP makes sense.
So in 2019, for example, the most you can put into an RRSP is $26,500. For, let's say, a 55-year-old individual, the most they could put into an IPP, if they had that instead, would be 10,000 more, $36,500.
- If we take a look at what that incremental room means over time-- you brought a chart in, and this really tells the picture well. Again, showing here at age 55, what can be available to you if you have an IPP?
- Right. So if you look at this chart, what we see is the blue line that tracks the cumulative RRSP contributions over time. And of course, there's a growth rate built into this. And the red line is showing us the cumulative IPP contributions over time. So those incremental $10,000, $12,000, $15,000 differences every year, we see that by age 70, we have more than $1 million extra in the IPP compared to the RRSP.
- And the nice thing you alluded to earlier is the fact that that pension is now inside the company, and there's something interesting that happens in terms of being able to pass that on to your children or whomever you want to pass it on. How does that work, and how is that different or better than an RSP?
- Right. So let's go to the basics. Let's look at the Canadian corporate tax 101. Basically, the Canadian tax system incentivizes a corporation by having them pay less tax if they earn the right kind of income. If you're earning active business income, you can get away with paying a lower rate of tax inside the company on that income when we compare it to an individual taxpayer outside and the top marginal rate outside.
So rational business owners and taxpayers will say, that's fine. I'll pay the low rate of tax. I'll leave the money in the company because that is a deferral, and I'll only pull out what I need to for my lifestyle expenses. So that money left in the company, those retained earnings, those balances typically build up over time. They're invested inside the company, but now these investment returns are taxable.
An IPP is sort of like a sponge, right? It's inside the corporation, not outside. I've said that before. And the sponge basically soaks up these retained earnings and puts them from a taxable corporate investment account into a tax-deferred pension account, basically making the pot bigger at the end. And the bigger the pot, more money for you, and more money for the kids.
- The other nice thing that can work is that there's more flexibility at retirement with an IPP. So with an RRSP, if I retire and I start receiving a pension, but I don't exhaust my RRSP fully, well, it becomes taxable at death. The same is true for an IPP as well. But if this is a multigenerational business where I have my children involved, there is an option for the kids to become part of that IPP. So they take over any leftover balance, and now we're not paying tax at death. The children can actually use this money for their pension.
- That's interesting. So if someone's listening to this and saying, yep, OK, this makes sense-- I want to start-- what are some of the things they need to start thinking about? I'm assuming this is not something you just structure in your spare time. You got to bring someone in.
- Right. I mean, it's nice to have a tax advisor, an accountant, an actuary, and of course, you have to have a corporation. You have to be paying yourself the right way. You have to be a connected employee. So get help from your tax advisor.
- Chris, thanks so much.
- Thank you.