Three myths about IPPs

The Individual Pension Plan (IPP) is a registered, company-sponsored DB pension plan specifically intended for entrepreneurs. But it remains a little-known, often misunderstood and underutilized retirement savings option.

Let’s look at three pervasive myths that may be preventing Canadians from using an IPP.

Myth 1: My clients are paying themselves in dividends, so the IPP is not really an option.

It’s true that dividends are not pensionable earnings and can’t be recognized in an IPP. It’s also true that dividends enjoy preferential tax treatment. But a dividend approach isn’t always more tax-efficient than paying out a salary and contributing to an IPP.

An IPP allows business owners to provide their companies with significant tax deductions while they accumulate more tax-sheltered retirement savings for themselves—up to twice as much as with an RRSP, notes the Canadian Tax Journal.

Take Bob, a 55-year-old business owner from Quebec whose company is paying the small business tax rate of 19%. He’s receiving the maximum yearly pensionable earnings ($144,500 in 2016) and was able to recognize 25 years of past service. He plans to retire at age 71.

Chart 1 shows the accumulation of funds with the 7.5% rate of return prescribed by the Income Tax Act to value liabilities and allowable IPP contributions, versus a 3.5% rate of return (more consistent with today’s economic context).

If Bob makes the maximum contributions allowed to an IPP, he could accumulate 12% to 17% more before taxes—5% to 9% more after taxes—at retirement than if he’d invested the maximum amount in an RRSP and paid himself in dividends instead. Even with preferential tax treatment for dividends, an IPP allows a business owner to accumulate more money for retirement, even in today’s low interest-rate environment. And its benefits increase as the corporate tax rate rises.

Myth 2: An IPP is strictly a defined benefit (DB) plan and can’t include a defined contribution (DC) component.

It’s possible to create a hybrid IPP that has both DB and DC components. This type of IPP is particularly beneficial for clients who own family businesses that employ a spouse and/or children.

The IPP Family Plan can offer a unique fiscal advantage in the event of the premature deaths of both the owner and his or her spouse. Rather than implement separate one-member IPPs for each family member, one single multi-member IPP is established. Because IPP contribution limits only become higher than RRSP limits after age 37, it’s possible to include terms in the IPP plan text to allow flexibility in contributions made by the plan sponsor for the different plan members.

For members younger than age 40, corporate contributions are made to the DC component. After age 40, it becomes advantageous to be part of the DB component of the plan, so members can elect to transfer from the DC to the DB component in order to contribute more money annually (via the company) to their retirement. This approach allows all plan members, regardless of their age when they joined the IPP, to accumulate the maximum tax-deferred retirement savings allowable.

The normal form of pension payable from an IPP is a lifetime pension, two-thirds of which reverts to the surviving spouse for his or her lifetime upon the retired member’s death. Upon the surviving spouse’s own death, any remaining assets are considered surplus and are fully taxable to the beneficiary or estate when the plan is wound up.

Profile of the ideal IPP candidate

The IPP is for clients who are:

• incorporated business owners or professionals;
• operating financially sound companies;
• 40 to 71 years of age; and
• receiving T4 income from their company.

There is no specific minimum salary to benefit from an IPP. After age 40, the IPP will always allow proportionately more contribution room than an RRSP. The closer the client’s salary is to the maximum pensionable earnings of $144,500 in 2016, the more beneficial the IPP is.

The IPP may help clients who are looking to:

• contribute significantly more retirement savings than is possible under any other registered savings plan, including an RRSP;
• accumulate more tax-sheltered and creditor-protected savings;
• reduce their corporate taxes;
• take some money out of their company in a tax-efficient manner at retirement;
• assure the financial security of their spouse; and/or
• support succession planning.

A surplus can remain in the IPP if at least one member remains in it. So, in the case of an IPP Family Plan, any surplus stays put and no taxes are paid as long as one member (e.g., a surviving child) keeps the IPP open. Any surplus assets are not paid out until the last member receives his own benefits, or the plan is wound up.

If there’s a surplus, it’s possible the company will be unable to make further tax-deductible contributions to the IPP for a number of years. This is because the Income Tax Act imposes a mandatory contribution holiday for all pension plans (including IPPs) when there are surplus assets in excess of 25% of the liabilities. However, taxes continue to be deferred on monies remaining in the plan until they are paid out as benefits or surplus when the plan is eventually terminated.

Myth 3: An IPP involves mandatory contributions and deficit funding.

This depends on the type of member and the province in which the plan is implemented. The IPP is subject to the terms and conditions stipulated in the Income Tax Act and applicable pension legislation, which includes stipulations about whether or not contributions and deficit funding are mandatory.

However, some provinces have recognized that business owners often implement IPPs for themselves. So, if required contributions and deficit funding aren’t made, the owner is often the only person affected.

Alberta, British Columbia, Manitoba and Quebec do not require mandatory contributions or deficit funding for an IPP implemented for a connected member (a person who owns, directly or indirectly, at least 10% or more of the sponsoring company). Prince Edward Island has not yet enacted pension legislation, so there are no funding requirements for connected or non-connected members there.

For connected members in Ontario and Saskatchewan, contributions are mandatory. But when it comes to deficit funding, benefits may be reduced (with the member’s consent) in order to match their value to the plan assets at windup and eliminate any residual deficit.

For connected members in federally regulated plans, and for IPPs established in New Brunswick and Nova Scotia, relief options may be possible at windup, but only with the consent of the pension regulator. Companies sponsoring IPPs in these jurisdictions must ensure they have sufficient cash flows to make the required contributions on an ongoing basis.

Newfoundland and Labrador is much stricter about mandatory contributions and deficit funding: once an IPP is in place, the plan sponsor has to pay up. Regardless, no matter where in Canada clients live, contributions and deficit funding are always mandatory if the IPP is implemented for a non-connected member.

When is an IPP not the best option?

Despite its tax efficiency, for a business owner in Newfoundland and Labrador, or for any company that is cash-sensitive and is sensitive to economic or market trends, the IPP may not be the best option because stricter funding regulations do not provide any relief options or flexibility regarding mandatory contributions and deficit funding. For some companies, the required investments may become too onerous and lead to financial hardship.

It’s also not the best fit for any non-connected individuals (people who do not own 10% or more of the sponsoring company, either directly or indirectly), since funding requirements for those individuals tend to be harsher. Company directors should understand the nature of the commitment they’re making to any employee getting an IPP.

An IPP is certainly more complex than an RRSP, but most of the complexity is regulatory in nature and is handled by the plan actuary. Actuarial fees for an IPP generally range from $1,200 to $3,000 per year.

Actuarial services include producing required valuation reports, sales support for advisors and annual plan administration. Some actuaries also offer ongoing strategic advice, from plan implementation to benefit payout or plan windup. It’s critical to keep the actuary informed of any anticipated changes in a client’s personal or corporate situation to ensure the best possible outcome for the business owner.

An IPP isn’t right for everyone. But with transparency, informed decision-making and professional support throughout the IPP’s lifecycle, it can be a success story for many business owners.

by Marc-André Vinson, principal, Ottawa Market Leader, Wealth Practice at Buck Consultants Limited, a Xerox Company.