An Individual Pension Plan is a type of defined benefit pension plan that many successful entrepreneurs may want to consider for their retirement as an alternative to RRSPs.
After all, while RRSPs make up an integral component of any retirement plan, they do come with limitations.
For starters, allowable contributions to an RRSP are limited to 18% of your annual income, up to a maximum of $26,230 in 2018.
As you can imagine, for so many self-employed individuals who don’t have access to a workplace pension plan, these limits on RRSP contributions could make it near impossible to fully fund their retirement.
Furthermore, RRSPs are a type of defined contribution plan. This means that while the employee has some control over the amount that they put into the RRSP during their working years, the income that they are able to generate during retirement is far from guaranteed.
Sustained poor market conditions, either during the accumulation phase of their investment, or after retirement, can severely reduce the investment holdings from which they need to draw income.
With a defined contribution pension plan, such as an RRSP, the employee assumes all of the risk.
This is where an Individual Pension Plan can help.
Its purpose is not to replace the RRSP as a retirement vehicle, but rather enhance a self-employed individual’s ability to create retirement income.
What Is An IPP?
An Individual Pension Plan (IPP) is a defined pension plan which is established by an incorporated company for the benefit of one individual.
The individual, usually the owner of the company, or an executive, usually initiates the request, as the IPP is to be established for their benefit.
As the owner of the company, providing that you are drawing a T-4 salary from the business, you can make contributions into your own IPP.
To draw a T-4 salary from your business, it must be incorporated. A sole proprietor is not able to set up an IPP.
Contributing to an IPP will help to boost your retirement savings while also reducing your company’s income tax burden.
Who Assumes the Risk of an IPP?
As I mentioned above, an IPP is a type of defined benefit pension. This means that the employer is assuming the investment risk, not the employee.
In other words, it’s the company’s responsibility to ensure the pension plan is sufficient to meet the income needs of the employee throughout their retirement, based on a set of predetermined conditions, which we’ll explore a bit later.
In fact, upon establishing an IPP, the company must ensure than an actuary has reviewed the pension plan, and certified that the contribution calculation of the plan meets legal requirements.
There are several rules by which an IPP is governed, but before we examine them further, let’s take a closer look at defined benefit pension plans.
What is a Defined Benefit Pension Plan?
A defined benefit pension is a plan which is paid out based on a formula related to age and years of service.
This means that an employee is able to determine precisely what their retirement income, or benefit, will be, based on the age at which they retire, as well as their number of years of employment with the company.
Unfortunately, this type of pension is quickly becoming extinct in many corporations that now favour a defined contribution plan (similar to an RRSP). With this type of plan, the payout at retirement is dependent on the performance of the underlying investment.
Why are Employer’s Moving Away from Defined Benefit Plans?
While employees love the retirement income security provided by a defined benefit plan, they’re far more expensive for employers to maintain.
That’s because with a defined benefits plan, the employer must ensure that the plan remains adequately funded for the duration of an employee’s retirement, regardless of how well the markets perform.
This creates a long term liability for the company, and may require them to periodically bolster plan assets by injecting huge sums of cash directly from corporate earnings.
Such an enormous financial commitment can have an adverse impact on profits, in an environment where companies need any competitive edge they can get.
How can an IPP Help Entrepreneurs?
Individual Pension Plans (IPP’s), make it possible for entrepreneurs to receive the many benefits of a defined plan that I’ve described above. But there are a number of criteria you must meet to qualify.
Let’s take a closer look.
Using An IPP
As I mentioned previously, if you own a company and receive T4 income from that company, an IPP can give you the benefit of a defined pension plan, where your payout is based on your years of service and your age.
An IPP allows a business owner to set up a defined benefit pension plan for themselves. In this arrangement, your company pays the majority of the contribution to the plan.
The amount that can be contributed depends on the income, years of service and age of the person.
Understanding the Rules of an IPP
The IPP is ideal for employees over age 50, but annual contribution limits begin to exceed those of an RRSP at age 40, so it’s common for plans to be opened earlier.
For example, the annual maximum contribution limit by age 50 is $31,488, well above the RRSP limit. By age 60, it increases to $38,005. These contribution limits are simply not available within a traditional RRSP.
It should be noted that funds contributed to an IPP are reported as a Pension Adjustment to CRA, which impacts the employee’s RRSP contribution room.
Since this pension plan can involve very large contributions, it’s obviously for well-off businesses that have some money to spare.
What’s in It for the Employer?
While the contributions tend to be large, the net amount paid by the company is reduced, as the contribution is a tax-deductible expense.
Let’s take a look at some of the rules for setting up an IPP:
- The sponsor must be an incorporated and active company; no holding companies.
- You must, as the plan member, be considered an “employee” earning T4 or T4PS income from the corporation. The company cannot be set up as a sole proprietorship.
- Documents related to the pension plan provide a formula for the amount of benefit earned by the member.
- There must be strict guidelines for plan investments.
- Business contributions to the IPP must be certified by an actuary in order to be deductible from corporate income.
- Remember that the money in an IPP grows tax-deferred. This means that when you receive distributions from the plan during retirement, you will have to pay taxes on the money and pay according to your current situation.
- Plan members must be residents of Canada when the plan is set up, and pay income taxes in Canada. While you can move outside of Canada later, and receive distributions even if you live outside Canada (you’ll still have to pay Canadian taxes on them), when the plan is set up, you have to reside in Canada.
Catch-Up IPP Contributions for Past Service
An IPP can be an excellent way for an entrepreneur or professional to “catch up” contributions for past service.
Years of service can go as far back as 1991, and for those who take advantage of this feature, the first year contribution could be over $400,000!
Many business people don’t have a lot of spare cash in the early years of their business to contribute to an RRSP, so the IPP can be a good way for them to quickly fund their retirement plan now that they have found business success.
Disadvantages of an IPP
For all of their benefits, there are some disadvantages to an IPP that companies should consider before opening a plan for an individual employee.
Let’s take a look at a few:
- Investment Pension Plans are more complex to set up than a basic RRSP plan. There are annual reporting requirements that must be fulfilled by the company.
- IPPs are also more costly to administer than RRSP plans, at the time of set up, and also on an annual basis.
- To maximize the contribution room, you need to be drawing a high income, in excess of $100,000.
- Contributions to an IPP reduce the amount of RRSP contribution room for the employee. This should be taken into account when building a retirement plan.
- Upon retirement, there are restrictions on how you can draw income from an IPP. Both federal and provincial pension legislation can dictate how income must be drawn. These options can be less flexible than other retirement investment vehicles.
There are also other considerations with an IPP that need to be fully understood before you set up this plan.
If you think an Individual Pension Plan might fit your own financial situation, be aware that this is a complex arrangement and you need to talk with a financial planner that is very experienced with benefit plans.
The IPP At-a-Glance
- Enables a self employed individual to contribute to a defined benefit pension plan.
- Contributions are tax deductible for the company, offering annual tax savings, while the employee doesn’t pay tax until they draw on the income in retirement.
- Contribution limits are higher than that of RRSPs, and increase as you age.
- An IPP allows an employee to catch-up, by making lump sum contributions for past service.
- Up to 50% of income received from an IPP can be split with a spouse for income tax purposes.
- IPP assets are protected from creditors, a benefit for self-employed individuals.
- offers the ability to make large, lump sum contributions for past service.