Service Cut Off: New Tax Treatment Curtails A Big Advantage Of Individual Pension Plans
Individual Pension Plans (IPPs) have grown in popularity among incorporated small businesses over the past decade as a way of allowing the owner to accumulate more retirement funds than otherwise possible through traditional RRSPs. An IPP is simply a defined-benefit Registered Pension Plan (RPP) established for the principal employee of a closely-held, controlled private corporation, or the principal's spouse or kids, who must also be employees.
The recent 2011 federal budget contained a major change to the tax treatment associated with funding a past service pension contribution, which can make establishing a new plan less attractive than it used to be. The amount you can contribute to a defined-benefit plan, including an IPP, is directly tied to RRSP contribution limits. As a result, an IPP member's annual RRSP contribution limit is reduced by the estimated amount of annual saving in his or her IPP.
When a small-business owner sets up an IPP, he or she is often given the option to make a contribution in respect of past service. To do so, however, the employee must either give up accumulated RRSP contribution room for earlier years or, to the extent that the employee has made RRSP contributions in those previous years, withdraw a portion of RRSP assets to fund the IPP. These RRSP assets are generally transferred in-kind to the IPP being established. Employees who switch from RRSP savings to IPP savings later in their careers are able to make a past service contribution to the IPP, which can be much greater than the amount the employees are required to reduce their RRSP assets or accumulated RRSP contribution room.
Under the new proposed rule, which is effective for past service contributions made on or after March 22, 2011, the cost of funding past service under the terms of an IPP must be first satisfied by transfers from RRSP assets, or a reduction in the IPP member's accumulated RRSP contribution room, before new past service contributions will be permitted. This limits the attractiveness of funding past years' service in situations where the RRSP has grown in value such that the entire past service IPP contribution would be funded through an RRSP transfer (or a reduction of room), because there's no opportunity for new net retirement savings accumulation.
IPPs are still beneficial for other reasons, but one of the biggest advantages has now been severely curtailed.