APPENDIX 9 - REGISTERED PLANS IN RETIREMENT PLANNING

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1 APPENDIX 9 - REGISTERED PLANS IN RETIREMENT PLANNING Topics in this section include: 1.0 Retirement Planning 1.1 Registered Retirement Savings Plans (RRSPs) 1.2 Registered Retirement Income Funds (RRIFs) 1.3 Registered Pension Plans 1.4 Options on Retirement 1.5 Income-splitting during retirement 1.0 Retirement Planning 1.1 Registered Retirement Savings Plans (RRSPs) The government allows people to save for retirement. Registered retirement savings of a person consists of the individual s RRSP a d his/her Registered Pension Plan (RPP) at his/her place of employment. Because there is a deduction allowed on these contributions, and these accounts are tax-deferred, the government restricts the amount that a person can save in these plans annually. The government states that a person can save the lesser of 18% of his previous ear s RRSP eligi le i o e, or a li it set a uall the go er e t. The RRSP contribution limit for 2010 was $22,000, and for 2011, it is $22,450. In other words, no one in Canada can save more than this limit in total in his pension plan and RRSP put together. RRSP-eligible income comprises income earned during the previous year from the following sources only: Earned Income for the purpose of an RRSP: Employment income; Self-employment income; Business income earned as active owner or partner; Employee profit-sharing plan allocations; Taxable disability benefits; Supplemental EI benefits; Royalties; Net research grants; Net rental income; and Alimony. Copyright 2011 Oliver Publishing Inc. All rights reserved 1

2 Deduct Alimony paid, union dues, and professional-association charges (Does not include: Interest, dividends, capital gains, scholarships, bursaries, business income as a limited partner, pension benefits, severance pay, retiring allowance, death benefits, amounts drawn from RRSP, RRIF, or DPSP.) As dis ussed earlier, the o tri utio roo of 18% of the pre ious ear s i o e is reduced by the pension adjustment (PA) of the previous year to arrive at the RRSP contribution room for this year. Also, any RRSP room that was earned in previous years but for which no contribution has been made (called the carry-forward room) is added to any roo ge erated for this ear to arri e at a perso s total RRSP roo. The formula to calculate total RRSP room is therefore: Total RRSP Roo = 18% previous ear s RRSP eligi le i o e PA + Carry Forward Room You will notice that all the figures used in the above formula are based on the pre ious ear s figures. The total RRSP roo that a perso a ha e a exceed the annual limit on RRSP contributions. The person may contribute up to his total room and get a deduction for tax purposes. Some of the defined-benefit plans may allow their members to make additional voluntary contributions for previous years of service. When a member makes such a voluntary contribution (if eligible to do so), such contributions reduce the total RRSP room of the member. Such voluntary contributions give rise to a past service pension adjustment (PSPA), which reduces the total room in the year that such a contribution is made. So the correct formula to calculate the total RRSP room of a person is: Total RRSP Roo = 18% previous ear s RRSP eligi le i o e PA + Carry Forward Room - PSPA You will note that the only figure that is a urre t ear s figure i the a o e calculation is the PSPA. Copyright 2011 Oliver Publishing Inc. All rights reserved 2

3 RRSP Eligible income Year Salary $60, $60, Bonus $10, $10, Commissions $12, $12, Net Rental Income $12, $12, Royalties $2, $2, Interest $2, Taxable Capital Gains $8, $106, $96, Less Alimony paid to ex-spouse $24,000 $72,000 Pension adjustment (PA) $5, Past Service Pension Adjustment (PSPA) $6, Carry-Forward room (end of 2011) $10, $24,000 Alimony RRSP Room for 2011 = Lesser of (18% of RRSP eligible income - PA + Carry-Forward room - PSPA, RRSP Limit) = Lesser of (18% x $72,000 -$5,000 + $10,000 - $6000, $22,450) $11, Cumulative excess amount (CEA) At any point that the Canada Revenue Agency (CRA) determines that the cumulative contributions made to date have exceeded the cumulative contribution room generated to date, the taxpayer has contributed a cumulative excess amount. The CRA allows a person to have a CEA of up to $2,000. If the CEA exceeds $2,000, the taxpayer has to pay a penalty tax of 1% per month on CEA over $2,000. Remember that the taxpayer could have deducted only up to his cumulative contribution room. The CEA amount therefore consists of after-tax dollars lying in the registered account Spousal RRSPs and income-splitting A taxpayer may contribute to an RRSP in hi h the perso s spouse is the annuitant out of his/her total contribution room. Therefore, a spousal RRSP is o e i hi h the perso is the o tri utor a d the perso s spouse is the annuitant. The contributor gets the deduction for tax purposes. Copyright 2011 Oliver Publishing Inc. All rights reserved 3

4 The idea behind a spousal RRSP is that, if the lower-income spouse, who is the annuitant, withdraws funds from an RRSP at a later date, tax would be paid at a lower marginal tax rate (MTR), thereby providing a tax saving to the couple. It makes more sense if the spouse that has a higher marginal tax rate contributes to a spousal RRSP, in which the spouse with a lower marginal tax rate is the annuitant. Because it may not always be possible to know which spouse will be at the lower marginal tax rate when funds need to be withdrawn, financial prudence dictates that a couple must try and keep their retirement savings at an equal level, so that they can take advantage of any differential tax rates that may exist at the time of withdrawal. Please ote that the a uita t spouse s o tri utio roo is ot affe ted i a way by a contribution to the spousal RRSP. Spousal RRSPs are a legal way to split income between spouses. However, as people could misuse this provision, the government has special attribution rules that apply to spousal RRSPs. If the annuitant spouse of a spousal RRSP withdraws money from the spousal RRSP in the year that the contribution was made or the following two calendar years, the withdrawn amount will be taxed in the hands of the contributing spouse. Copyright 2011 Oliver Publishing Inc. All rights reserved 4

5 Examples that deal with spousal RRSPs Assume John and Mary are spouses John has a marginal tax rate (MTR) of 40% and Mary has an MTR of 22% Total room Contribution to own RRSP Contribution to spousal RRSP (Mary is annuitant, John the contributor) John 2008 $18,000 $5,000 $13, $19,000 $8,000 $11, $22,000 $10,000 $12,000 $59,000 $23,000 $36,000 Tax $23, Assume that John does not contribute to spousal RRSP until In 2013, if Mary withdraws $10,000 from the spousal RRSP Mary will pay a tax of $10,000 x 22% = $2,200 In 2013, if John withdraws $10,000 from his own RRSP, John will pay a tax of $10,000 x 40% = $4,000 Clearly a tax saving of $1,800 for the couple 2 If Mary withdraws $10,000 in 2011, attribution rules will apply and the entire $10,000 will be taxed in John's hands 3 If Mary withdraws $25,000 in 2011, attribution rules will apply and the contributions of the previous two years will be taxed in John's hands and the balance will be taxable to Mary. Copyright 2011 Oliver Publishing Inc. All rights reserved 5

6 Therefore $23,000 will be taxed to John and $2,000 to Mary. Please note that it does not matter from which account Mary makes the withdrawal. For tax purposes, CRA uses the last-in-first-out (LIFO) system and will deem that the withdrawals were made out of the latest contributions RRSP maturity date and options RRSPs mature on December 31 of the year the annuitant turns 71 years of age. I other ords, the go er e t a ts o tri utio s to a perso s RRSPs to e d in the year the taxpayer turns 71. The taxpayer may, however, continue to contribute to a spousal RRSP, if their spouse is younger than 71 and the taxpayer has contribution room, and the taxpayer may obtain a deduction for tax purposes. The options of an RRS at maturity are the following: 1. Withdraw the funds in a lump sum and pay tax at the ta pa er s MTR o such a withdrawal. 2. Transfer the funds to a registered annuity and pay tax annually on the payments received from the annuity. 3. Transfer the funds to a Registered Retirement Income fund (RRIF) and pay tax gradually as funds are withdrawn. 1.2 Registered Retirement Income Funds (RRIFs) Can be opened at any age. A minimum withdrawal is to be made from the fund every year beginning the year after the RRIF is opened. Payment can be based on the age of the annuitant or the spouse of the annuitant. Percentage of withdrawal (minimum): 1 (90 age) x market value at beginning of year or can be based on CRA tables. Qualifying (established 1992 or earlier). Non-qualifying (established after 1992). Minimum percentages different from age 71 to 77. No maximum Can be closed at any time. Copyright 2011 Oliver Publishing Inc. All rights reserved 6

7 A RRIF account may hold the same investments that an RRSP account may have, and the fair market value (FMV) of the RRIF fluctuates, depending upon the kind of investment vehicles chosen. The FMV of a RRIF is determined at the beginning of each year. The CRA has tables and, depending upon the age of the RRIF annuitant, a minimum withdrawal has to be made from the RRIF in the year following the year the RRIF was established. There is no minimum age for opening a RRIF account. A RRIF account cannot receive contributions. It needs to be set up from a transfer of funds from a RRSP account or by transfer from another RRIF account. Gi e elo are the CRA s RRIF ithdra al ta les: Minimum Withdrawals from a RRIF Age Percentage for qualifying RRIFS Percentage for non-qualifying RRIFS Under 68 1 (90 age) 1 (90 age) Copyright 2011 Oliver Publishing Inc. All rights reserved 7

8 Qualifying RRIFs are those that were set up prior to All other RRIFs are non-qualifying RRIFs. You will notice that there is a difference in the percentage to be withdrawn for the years between 71 and 77. For ages below 68, the minimum percentage is calculated as minimum percentage = 1 (90 age) The age in the table above refers to the age of the RRIF holder, unless he/she elected to base the RRIF on the age of his/her spouse. 1.3 Registered Pension Plans Registered pension plans are employer-sponsored. Both the employee and employer make contributions to the plan. There are two kinds of pension plans, namely: 1. Defined benefit plans 2. Defined contribution plans Defined Benefit Plan In a defined benefit plan, the benefit to be received by the employee from the plan is fixed, for example as a 1% plan or a 1.5% plan or a 2% plan. (The government allows for a maximum of 2%). This means that the employee is promised the fixed percentage of his annual pensionable earnings as the benefit for each year of service while he was a member of the plan. Example: John has been a member of his 2% defined-benefit plan for 30 years. Given below are the necessary details concerning John: Career average earnings over 30 years $50,000 A erage of his est three ears ear i gs $80,000 A erage of his fi al three ears ear i gs $70,000 Copyright 2011 Oliver Publishing Inc. All rights reserved 8

9 There are four variants of this plan: 1 A career-average plan: If the plan John belonged to was a career-average plan, his benefit would be calculated as: Career average earnings: $50,000 Benefit per year of service (2% x Career average earnings) $1, Plan benefit to be received per year $30, ($1,000 per year of service x 30 years of service) 2 Best three years earnings plan: If the plan John belonged to was a best three years earnings plan, his benefit would be calculated as: Average of best three ears ear i gs: $80,000 Benefit per year of service (2% x Career average earnings) $1, Plan benefit to be received per year $48, ($1,600 per year of service x 30 years of service) 3 Final three years earnings plan: If the plan John elo ged to as a fi al three ears ear i gs pla, his e efit ould e calculated as: A erage offi ial three ears ear i gs: $70,000 Benefit per year of service (2% x Career average earnings) $1, Plan benefit to be received per year $42, ($1,400 per year of service x 30 years of service) Copyright 2011 Oliver Publishing Inc. All rights reserved 9

10 4 Fixed-benefit plan: If the plan John belonged to was a fixed-benefit plan ($800 per year of service) his benefit would be calculated as: Benefit per year of service (2% x Career average earnings) $ Plan benefit to be received per year $24, ($800 per year of service x 30 years of service) If funds are short in the defined-benefit plan to meet its promised obligations, the e plo er eeds to ake good this shortfall. The e plo ee s o tri utio and the benefit are fixed entities. Therefore, the pension adjustment that arises for a member of a defined-benefit plan is calculated as: Example: If john has a pensionable income of $50,000 this year and belongs to a 2% defined-benefit plan, and he and his employer each contribute 5% of pensionable earnings, his PA will be 9 x (2% of $50,000) $600 = $8,400 In a defined-benefit plan, the employer faces the investment risk, as any shortfall in the fund needs to be made good by the employer Defined-contribution plan In a defined contribution plan, both, the employer and the employee contribute a fi ed per e tage of the e plo ee s pe sio a le ear i gs. The fu ds are invested and made to grow. When the employee retires, the value that accrues in his account is used to buy him the benefit. Thus if the fund does well, the employee gets a better benefit and vice versa. Therefore in a defined contribution plan the employee faces the investment risk. Copyright 2011 Oliver Publishing Inc. All rights reserved 10

11 Example: If john has a pensionable income of $50,000 this year, and belongs to a defined-contribution plan, and he and his employer each contribute 5% of pensionable earning, his PA will be: PA = $2,500 + $2,500 = $5, Options on Retirement On retirement, a member of the pension plan can choose from the following options: 1. Take a pension from the plan in the form of a pension annuity. 2. Transfer the funds to a Life Income Fund (LIF). 3. Transfer the funds to a Locked-in Retirement Income Fund(LRIF). The plan member has to exercise one of these options before December 31 of the year he/she turns 71 years of age and start receiving income in the year he/she turns 72 years of age. If the member is retiring from the plan before 71, he may defer receiving income from the plan until he/she turns 72 by transferring the fund to an account called a LIRA (Locked-in Retirement Account) or buying a deferred-life-annuity contract in which payments will commence in the year he/she turns 72 years of age. The pension annuity option pays out a pension to the pensioner and a survivor pension to the spouse of a pensioner. The Life Income Fund option is similar to the RRIF account. There is a minimum amount that has to be withdrawn based on the same RRIF tables. However, there is a maximum amount that can be withdrawn, which is based on an annuity calculation to age 90. The maximum is an amount determined by multiplying the balance at the beginning of the year by a prescribed annuity factor, which depends on an interest rate and the owner's age. So a LIF annuitant can withdraw any figure between the minimum and the maximum amount for the year. The maximum is specified, because pension funds are locked in and cannot be cashed out in a lump sum by the pensioner. The LRIFs are available only in certain provinces. The minimum withdrawal from a LRIF is ased o the RRIF ta les. The a i u is ased o the pla s investment earnings. 1.5 Income-splitting during retirement If both spouses are over 65 years of age, they may split their retirement incomes so that each is taxed on 50% of their retirement incomes. Copyright 2011 Oliver Publishing Inc. All rights reserved 11