In light of all the changes proposed by the Federal Liberal Government in July 2017, the sensitivity around the excessive taxing of small business owners has raised some eyebrows. The proposed changes took into consideration heavily taxing any passive income that exists within a business, scrutinizing how business owners sprinkle income to family members and some other controversial measures. Even though the Liberal government have moved forward with a few measures, modified other recommendations and deferred other recommendations, the question begs to be asked, how can business owners fund their retirement.
The promising thing is there are still some viable and tax-effective means in which business owners can build wealth within their business. Although there are many different strategies, the four primary means of business owner retirement planning are contributing to Registered Retirement Savings Plan (RRSP), an Individual Pension Plan (IPP) or Personal Pension Plan (PPP), an Insurance Retirement Plan (IRP) and a Retirement Compensation Arrangement (RCA)
For some business owners, an RRSP is a successful way to save for retirement, but for many, it’s not enough. If you are 45 years of age or older and have an income of $100,000, your RRSP contributions are limited to current maximums. To maintain your current lifestyle in retirement, you may want to consider a Personal Pension Plan, an Insured Retirement Plan or a Retirement Compensation Arrangement as an alternative retirement strategy.
An RRSP is the most common registered retirement vehicle for employees. Still, for business owners, there are some very appealing and tax-efficient alternatives with greater contribution room and depending upon how it is set up can be funded by the business, either as a total business expense or paid out of retained earnings.
What is an Individual Pension Plan?
The IPP allows a business owner to fund his/her own pension funded by the business. It is subject to the Canada Pension Laws, and the assets are completely creditor protected. It can be a Defined Benefit (DB) Plan, with the Rate of Return guaranteed by the sponsoring company. Yet, in years where the business can’t afford to fund the entire DB amount, it has the flexibility to convert to a Defined Contribution Plan (DC) where the funding requirements are far less cash-intensive. You can roll your previous RRSPs into the pension to further creditor-protect those personal assets. You also have the ability to contribute for previous years experience and terminal fund your pension if you choose to retire early. All the administrative fees, past, current and future and commission fees can be expensed by the business. It’s also a great vehicle to help cleanse your business of any passive assets to help meet the requirements to qualify for the Lifetime Capital Gains Exemption (LCGE) when looking at selling your business. See here about a more in-depth look at why the Individual Pension Plan might make sense for you.
Summary of an Individual Pension Plan
- Annual contribution amounts are larger than an RRSP
- Opportunity to make additional contributions for early retirement benefits
- Moves corporate money into an individual’s hands on a tax-deferred basis
- Employer contributions exempt from CPP and other payroll taxes
- Retirement income is defined.
- Flexibility to be either Defined Benefit or Defined Contribution pension on a year to year basis
- Contributions and plan administrative expenses are deductible by the business
- Pension benefits are creditor protected under pension legislation.
What is a Retirement Compensation Arrangement (RCA)?
An RCA is an arrangement as defined in the Income Tax Act in which an employer or former employer makes contributions to a custodian on behalf of a high-income earner that wishes to sustain their standard of living into retirement. It allows for larger contributions than with RRSPs and IPPs and thus allows an opportunity to increase retirement assets to the maximum allowable level.
The mechanics of an RCA work as follows: an employer establishes an RCA on behalf of an employee for $100,000 per year for the tenure of the employee’s employment, in this case, let’s say it’s 10 years.
In year 1, the $100,000 goes into the RCA, $50,000 goes into a self-directed Investment Account, and $50,000 goes into a Deferred Tax Account. The Deferred Tax Account lies in trust in the government’s coffers earning nothing, and the Investment Account grows/shrinks at the selected investments Rate of Return. Half of the growth of the Investment Account gets transferred into Deferred Tax Account. Therefore a significant amount of the RCA doesn’t earn anything.
When it comes to drawing from the RCA, for every dollar that is drawn from the Investment Account, 0.50 is drawn from the Deferred Tax Account. The entire amount drawn from the RCA is taxed at the individual’s Marginal Tax Rate on that given year.
Summary of the Retirement Compensation Arrangement (RCA)
- Significantly higher contribution limits than registered plans
- Can be set up by the owner of an incorporated or sole proprietorship
- Immediate business expense deduction to the employer and no taxes to the employee until it’s paid
- Flexible and self-directed investment options
- Allows deduction at current high tax rates and deferral of income by the employee to future years and potentially lower tax rates
- The RCA is completely secure as the custodian holds funds in trust
- Does not affect RRSP or IPP contribution limits
- 50% of RCA sits in Deferred Tax Account and doesn’t accumulate any increase in value but nor is it subject to tax
- RCA is drawn from Investment Account and 50% from Deferred Tax Account at the individual’s marginal tax rate.
What is an Insured Retirement Program (IRP)?
An Insured Retirement Plan is a strategy designed to meet the dual need for insurance protection and a supplement for retirement income in the future. This can be funded in the hands of the business owner in after-tax dollars or funded through the corporation in after corporate tax dollars but before income tax dollars. If done through the corporation, it can be done in a tax-preferred way leveraging a Guaranteed Fee Arrangement. A Guaranteed Fee Arrangement is a payment plan by the business owner of the corporation.
In either way, corporately owned or personally held an IRP could have significant tax consequences if the proceeds are not accessed correctly because current rules under the Income Tax Act allow the cash value in a life insurance policy to accumulate tax-free up to certain limits. This strategy allows the business owner to purchase an exempt life insurance policy and creates cash value above what is required to pay for the life insurance policy. At retirement, the insurance policy, or rather the accumulated cash value within the life insurance policy can be used to secure a loan structured similarly to a line of credit. The borrowed funds are received tax-free and may be used to supplement retirement income. At death, the insurance proceeds repay the loan, and any excess amount of proceeds are paid out to the beneficiaries. Here are some greater insights into why an Insured Retirement Plan may be a great solution for your retirement.
Summary of an Insured Retirement Plan (IRP)
- Premium dollars accumulate in a tax-sheltered basis within the life insurance policy
- The owner can withdraw or borrow accumulated cash value on a tax-preferred basis
- Contributions grow tax-sheltered above RRSP, RPP limits
- Contributions don’t need to be T4’d income, therefore can be dividend income or funded through retained earnings within the corporation
- A business owner can set up IRP for his or herself, or select employees within a corporation
as a fringe benefit or means of internal buyout mechanism
- Can allow the owner of the policy to creditor protect the assets with a designated beneficiary.
Although all the above vehicles represent tremendous retirement savings opportunities, depending upon your income levels, a PPP represents greater room than an RRSP. An RCA may be a great vehicle for those earning over $150,000 after a PPP has been utilized. Funding an IRP is independent of income; however, it must be subjected to underwriting approval to qualify.
Chris Coulter is the Founder and President of The Finish Line Group. He works with business owners to leverage their businesses to increase their wealth, reduce corporate and personal taxes, create viable succession strategies, enable employee retention strategies and allow them to exit their businesses on their terms.
Chris’ passion for what he does evolve from the mistakes he made in his first business; by not diversifying his risk and not utilizing a lot of the opportunities within his business to create significant wealth. Chris found out the difficult way and now educates business owners on how to avoid many of his former oversights and ultimately control where their finish line ends.
How can business owners fund their retirement