In our last article, Tax strategies for owner-manager remuneration, we discussed some common considerations for owner-manager remuneration and the related tax issues. Planning for retirement is part of those strategies, and in this article, we will look at pension options for the owner-manager. These comments will apply to the entrepreneur who operates their business in a Canadian-controlled private corporation (CCPC).
For the owner-manager, we will discuss the following three pension options:
- Registered retirement savings plans, RRSPs
- Canada Pension Plan, CPP (or the equivalent in Quebec, the Quebec Pension Plan, QPP)
- Individual Pension Plans, IPPs
All three of these options require a payment of salary or bonuses as part of your remuneration strategy. Where corporate profits are retained because funds are not currently needed for personal expenditures or personal investments, a different strategy other than pensions to fund retirement will be used.
In general, a pension is a plan funded by an employer to make payments to an employee in retirement. A pension plan can be contributory, in which case the employee also contributes to the plan, but it can also be fully funded by an employer. In Canada, pension plans are defined by provincial legislation; there is no separate definition in the Income Tax Act (ITA). Although a Canadian pension plan must be registered with the Minister of National Revenue to be accorded treatment as a pension plan under the ITA. In general, pension plans have statutory contribution limits.
We have included RRSPs in this article, as they have similarities to defined contribution pensions in Canada in that:
- There is an annual limit to contributions that can be made in respect of any year’s service
- A contribution is tax-deductible to the contributor within limits
- Earnings within the plan and amounts contributed to the plan are not subject to tax until withdrawal
- The plan must start to distribute funds at retirement or at a given age
- They have similar investment restrictions to registered pension plans
RRSPs have more flexibility than pensions in that withdrawals can be made at the discretion of the RRSP annuitant and can be made at any time—far earlier than the traditional retirement time frame. An annuitant is the person who is entitled to the funds from an RRSP. Unless the RRSP is a spousal RRSP, the annuitant will be the contributor. Another benefit of an RRSP is the ease of setting one up, and the portability of the plan—that is, it is always your plan and is not employer dependent. In a self-directed RRSP, the annuitant can make the investment decisions. Unlike CPP and registered pensions, the funds in an RRSP can provide funds to the annuitant’s estate. Pensions are for an individual and may pass in a reduced form to their spouse but will cease once the annuitant and their spouse are both deceased. RRSPs can pass into an estate, and once tax is paid, the after-tax funds will be part of the estate assets that can be passed to the next generation.
To make an RRSP contribution you must have salary (earned income) in the previous taxation year. The RRSP contribution is limited to the lower of 18% of earned income in that previous year, or a legislated annual limit. The annual limit for RRSP contributions in 2022 is $29,210 and in 2023 it is $30,780. To make these maximum RRSP contributions would require a respective salary of $162,278 in 2021 and $171,000 in 2022. Unused contribution room carries forward, but no contribution can be made after Dec. 31 of the year you turn 71 years old. In addition, contributions do not need to be deducted in the year contributed—they also can be carried forward and deducted in a future year. Contributing when you have the funds will allow the investment growth to be tax sheltered, even if you don’t deduct the amounts in the year you contribute.
Keep in mind that there are penalties for contributing more than your RRSP limit, although an overcontribution of $2,000 can sit in the plan without attracting penalties. Although not the stated intention of RRSPs, they can be used for income averaging—reducing income by contributing during high-income years and making a withdrawal in low-income years. However, RRSP contribution room cannot be replenished, so if this strategy is followed, funds available for retirement will be diminished.
It is also possible to use your RRSP contribution room to contribute to an RRSP where your spouse or common-law partner is the annuitant, “a spousal RRSP.” This allows assets to be accumulated in your spouse’s name, facilitating income splitting when funds are withdrawn from the RRSP. Note that when using a spousal RRSP, where funds are withdrawn within three years of contribution, the withdrawal will be taxed on your tax return, and not your spouse’s return, eliminating the income splitting benefits of that withdrawal.
Once you reach age 65, pension income splitting is allowed on your income tax return with respect to RRSP withdrawals if the RRSP withdrawals are in the form of an annuity. Under these rules, you can elect to have up to half of your qualifying RRSP withdrawal taxed on your spouse’s tax return.
Further information about RRSPs can be found by reading our Tax Bulletin - Answering your RRSP questions.
As an owner-manager, making these salary payments comes with the cost of contributing to the CPP. Unlike regular employees who only pay the employee portion, as the employer you will also pay the employer portion of CPP premiums.
In 2019, the structure of contributions and benefits of the CPP was changed, to increase both contributions and benefits. Contribution rates for both employers and employees have been increasing since 2019. In 2024, a second phase of structural changes will be implemented. This will result in significant increases in CPP premiums when an employee earns more than approximately $70,000 per year. As this limit is subject to inflation-related indexing, the actual limit is not known at this time. However, using data provided by the CRA, we have estimated that combined employer and employee CPP premiums will increase by approximately $1,650 between 2022 and 2025, or by 24%, where earnings exceed approximately $80,000 in 2025.
Owner-managers of incorporated businesses have the choice to pay salaries or dividends to extract funds from their companies for personal use. For individuals who have close to the maximum 40 years of contributions to the CPP, you may want to consider paying dividends to avoid the increased CPP premiums starting in 2024, given that the increased premiums will not result in any significant increase in your CPP pension. Unlike defined benefit pension plans which are often based on the highest earning years, the CPP is based on a career average of earnings, where the amount per year is not greater than the MPE set by the government for that year.
However, for younger entrepreneurs, the choice to pay or not pay salaries in order to avoid CPP premiums is subject to other considerations such as:
- Paying into CPP will diversify your sources of retirement income
- You will need to be confident that you can take the savings from not paying CPP premiums and invest the funds to make a better return than participating in the CPP (as paying CPP now is a form of forced savings)
- You will not be able to contribute to an RRSP if you do not have a salary
- You will not be able to “top-up” CPP at a later date to make up for forfeited contributions today
For more information on the CPP and CPP benefits, see our article Canada Pension Plan - Retirement considerations.
Note that is it possible to share CPP benefits with your spouse, which can be done by making application to Service Canada.
IPPs are a form of defined benefit pension plan and can be set up for just one person. An IPP is established by the employer corporation, and it is funded by the corporation, but it can be tailored for the needs of the employee—i.e., the owner-manager. It is first a pension plan, and as such, it is subject to provincial pension rules and administrative requirements.
Establishing an IPP is often seen in a situation where the owner-manager has worked for their corporation for a long period of time and has not put aside retirement funds outside the company. When an IPP is set up, an actuarial evaluation is required to determine the funding requirements for the pension for current service and for past service with that company. The most significant initial contribution will be for past service, which requires a history of paying yourself a salary from your company. IPP contributions set by the actuarial report are paid from the company and are deductible to the company in the year paid, or in the previous tax year if it is paid within 120 days of that tax year-end. Updated actuarial reports will be periodically required to ensure that the plan is adequately funded.
For an older entrepreneur (over age 50), the initial funding requirement will be higher than for a younger employee and is likely to be more than what could be paid into an RRSP. Note that participation in an IPP will almost eliminate an entrepreneur’s ability to continue contributing to an RRSP, in the same manner as a regular pension generally restricts an employee’s RRSP contribution.
Although more complex to set up than RRSPs, IPPs can provide security from creditors, and flexibility in the timing of contributions. As mentioned above, IPPs also offer greater contributions if the circumstances fit. As an IPP, the plan is funded to provide defined benefits, which will allow for additional contributions to the plan in the event of poor investment performance of the invested assets. As contributions to an RRSP are fixed, this is not something that can be done with an RRSP.
The main disadvantage to setting up an IPP is the administrative cost of compliance with filing requirements and actuarial evaluations. In addition, the IPP is a liability of the company. If the company is sold, arrangements will need to be made at that time for continuing the pension plan or transferring the assets of the plan to another vehicle, such as a locked-in retirement account.
Retirement payments from a pension plan qualify for pension income splitting on your tax return—the taxation can be split between your and your spouse or common-law partner. For a more complete assessment of the viability of an IPP to your situation, please contact your BDO advisor.
BDO can help
Planning for retirement at any stage in your career is complex, and must be customized for you, your risk profile, and circumstances. Decisions you make today can have long term implications. Your BDO tax advisors understand this complexity and can assist in reviewing your choices to help reach a plan that is right for you. Contact us today.
Rachel Gervais, Managing Partner, Tax
Greg London, Partner, Domestic Tax Consulting Leader
The information in this publication is current as of November 18, 2022
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.