Jan 2015
IPP vs RRSP: Why Business Owners Should Consider an Individual Pension Plan (IPP)
Knowing the difference between an IPP vs. an RRSP is crucial for any business owner. In this article, I’ll explain the pros and cons of each and provide context for choosing between them.
What is an IPP in Canada?
An IPP (individual pension plan) is a lesser known but highly-attractive vehicle for business owners and incorporated professionals. It allows you to save significantly more than you would under current RRSP rules while saving taxes and enjoying an increased level of creditor protection.
Per the CRA, individual pension plans must have fewer than four members. At least one of them must be related to a participating employer.
How do individual pension plans work?
Let’s now look at some more information regarding how individual pension plans work. Essentially, an IPP in Canada serves two roles. It is a defined benefit pension plan that allows greater tax-deferred contributions than an RRSP and, upon retirement, an annual pension income that takes into account your years of employment and level of T4 income.
A defined benefit pension plan provides security in that you’ll know how much you’ll receive in pension benefits each year – an important characteristic given the vagaries of the capital markets. RRSPs, on the other hand, do not provide the certainty of a fixed income at retirement.
IPPs are designed to be a sort of miniature version of one of the large-scale public sector pension plans such as the Canada Pension Plan Board, which looks after our Canada Pension Plan benefits.
Benefits of opening an IPP in Canada
Next, let’s look at the benefits of opening an IPP in Canada.
Designed for high-income business owners and professionals
The IPP was designed specifically for high-income business owners and incorporated professionals such as doctors, dentists, lawyers, accountants, pharmacists, and other professionals who draw T4 income.
Using Canada Revenue Agency rules, you can decide each year whether your IPP pension benefit will be accrued using a defined benefit plan method or the more traditional defined contribution plan method. In contrast to defined benefit plans, defined contribution plans do not provide a fixed amount of funds at retirement; with defined contribution plans, what’s “defined” is the amount of money you put into them.
IPPs offer higher contribution limits than RRSPs
Using the IPP, you can increase the size of your nest egg by making higher contributions every year—as much as 65 percent higher than those allowed under RRSPs, depending on your T4 income and years of service.
That can translate into a major difference in the ability to save for the future versus an RRSP. Here’s an example of a client, who is a 55-year old business owner and has been incorporated for 10 years.
Let’s assume she has saved $285,714 in RRSPs and makes the maximum contributions each year until age 65. As you can see in the accompanying chart, if this business owner stays in RRSPs, a total of $1,570,905 will have accumulated at age 65. However, if she invests instead in an IPP— and makes the higher annual contributions—she will have $2,272,001 at age 65. That’s a difference of $701,096, or 45 percent more than if she had used RRSPs to save for retirement.
Does your cash flow vary year to year? IPPs provide flexibility
The option of having your IPP pension benefit accrue using either a defined benefit or defined contribution method gives you flexibility. It allows you to switch every year between the two kinds of plans depending on the cash flow needs of your business. Less cash flow means you can switch to the less expensive defined contribution option.
IPPs offer creditor protection and other benefits
An IPP also offers a number of tax deductions to your corporation, including on all investment and administrative fees.
Moreover, unlike RRSPs, IPP assets enjoy creditor protection by provincial legislation.
As well, by using an IPP, you have greater access to investment vehicles. You can choose options other than those allowable for an RRSP, including shares of private businesses and real estate. By contrast, RRSPs are not creditor proof in Ontario unless you have declared bankruptcy. Even then, any RRSP contributions made in the 12 months prior to declaring bankruptcy are not protected. Some RRSPs can be creditor protected if issued by a life insurance company.
IPPs allow wealth transfer tax-free
Here is a special feature of the IPP unavailable in your RRSP. Most Canadian don’t realize their RRSP will be fully taxed on the death of the second spouse. An RRSP can only be rolled over on a tax-deferred basis to a spouse or disabled child. Where there is no spouse, the RRSP gets fully taxed in the year of death. If your spouse or children are employed in your business and earning T4 income, they are eligible to become members of the IPP. In this way, the IPP assets can pass to the next generation without incur- ring tax or probate fees.
Transferring assets from an RRSP to an IPP in Canada is simple
Another attraction of IPPs is that they have a special subaccount, known as the Additional Voluntary Contribution account. Using this, you can transfer any remaining RRSP assets into the IPP, and obtain the tax deduction of fees and the creditor protection of plan assets available under a pension plan.
Downsides of opening an IPP in Canada
No financial account is right for everyone. Here are some of the downsides associated with opening an IPP in Canada.
IPPs are costlier to create and maintain
Before setting up an individual pension plan, you’ll want to make sure the potential financial benefit exceeds the typical recurring administrative costs, which can amount to thousands of dollars annually. This is small potatoes to the Canadians best suited to utilize IPPs. For average earners, however, it can exceed annual gains.
Why are the fees so high with an IPP? Well, the CRA enforces very strict compliance when it comes to IPPs. Pension administrators and actuaries must go to great lengths to ensure the fund does not run afoul of the rules. Otherwise, it could be deregistered, which would create substantial tax consequences.
IPPs decrease your RRSP contribution room (including for spousal accounts)
When you make contributions to your IPP, you limit your allowable RRSP contributions – including to your spouse’s account. Keep in mind, however, that you can add your spouse to the IPP as long as they work for the same employer as you.
Changes to pension income splitting have also made this downside less of an issue than it once was.
What is an RRSP?
The registered retirement savings plan (RRSP) is Canada’s basic retirement savings vehicle. It was introduced by the federal government more than thirty years ago to help people save for the years they will need to pay for once they’ve retired. It is also the most popular, with over 59 percent of Canadians saying they have contributed to an RRSP according to a recent poll by the Royal Bank of Canada.
Benefits of an RRSP in Canada
Next, let’s look at the pros and cons of RRSPs in Canada, starting with the positives.
Incredibly straightforward and accessible
You can set up an RRSP within minutes at most major Canadian financial institutions. Unlike with an IPP, the rules are also relatively straightforward; you’re allowed to contribute 18% of the previous year’s taxable income up to a limit of $27,830 as of writing (this limit typically rises each year – see the latest numbers on the Government of Canada website).
Because RRSPs are so straightforward, just about anyone is capable of opening one and reaping the financial benefits. They’re not just geared towards high-income earners, as is the case with IPPs. Of course, this also has a downside, which we’ll explore shortly.
Contributions are tax-deductible
The government allows you to deduct RRSP contributions from your taxable income for the year. This has the effect of lowering the amount of taxes you pay for the year.
Again, the process for maintaining an RRSP and taking advantage of this is remarkably easy. There’s really no ongoing maintenance to worry about beyond ensuring your tax preparer receives your contribution slips at the end of each year.
Your investments will grow tax-free
You can invest in a variety of assets via your RRSP, including:
- stocks
- bonds
- options
- mutual funds
- exchange-traded funds (ETFs)
- guaranteed investment certificates (GICs)
Many of these assets have the potential to generate tremendous returns, especially over the long haul. You won’t pay any annual capital gains taxes on these profits as long as you hold them within your RRSP.
Taxes are only incurred once you withdraw money from the RRSP, the idea being that you should be in retirement and at a much lower tax bracket by that point.
By letting your investments grow tax-free like this, you’ll benefit from compound interest, which can result in dramatically higher gains before you ever have to worry about taxes.
You can easily withdraw money from your RRSP to buy a home or fund your education
The Home Buyers’ Plan allows Canadians to withdraw money from their RRSP taxation free to fund a first-time home purchase. The Lifelong Learning Plan, meanwhile, offers the same benefit for those looking to fund an education. In other words, you have tremendous flexibility to save within an RRSP while still making important purchases in life.
Downsides of an RRSP in Canada
Next, let’s look at the downsides of opening an RRSP in Canada.
You’ll miss out on the benefits of an IPP
If your financial situation makes you better-suited for an IPP, there’s really no question as to which type of account you should open. As demonstrated in the section on IPP benefits, the financial advantages can amount to millions of dollars over the course of your life.
In other words, an IPP is a no-brainer if you’re a successful business owner looking to maximize the growth of your retirement savings over the long haul. You stand to gain far more than the comparatively paltry benefits you’d receive from an RRSP.
Wealth transfers are more complicated
One key downside worth highlighting with RRSPs is that they make wealth transfers significantly more complicated with the potential for higher taxes. As mentioned earlier, you can only roll over an RRSP to your spouse or a disabled child. If you have neither, the RRSP will be taxed fully upon your death.
Your contribution room will likely not be enough to sufficiently reduce taxation
As mentioned earlier, your RRSP room is calculated as 18% of your pre-tax income, up to a limit of $27,830. While this is enough to significantly reduce taxes for an average employee, it’s really not much to a high-earning business owner. This makes RRSPs tax-inefficient in this scenario.
IPP vs. RRSP: Tips for planning your financial future wisely with these accounts
As a financial advisor to business owners and professionals, there are generally three questions I am asked:
1. When will I be able to stop working if I don’t want to work anymore?
2. Will my family be looked after financially if I get sick or hurt?
3. Will my family be looked after financially when I die?
The last two questions are usually answered by a customized form of insurance, tailored to your specific needs.
The first question confounds most Canadians. Most published reports indicate that baby boomers are not prepared for retirement, with many mired in debt. Not having enough money for retirement is a top financial concern.
A myriad of reasons may explain their nervousness. To list just some of the most obvious factors: the decline of employer-sponsored defined benefit plans; the 2008 stock market crash and the recession that followed; and, as part of the “sandwich generation,” many baby boomers are now caring for both elderly parents and adult children who are unable to find work.
Move over, with advances in healthcare allowing Canadians to live healthier and longer, people need even more money to provide for themselves as they age. Living longer in a prolonged era of historically low-interest rates adds to financial discomfort and uncertainty as savings are spent.
Yet, there are two steps most everyone can take to gain greater confidence in their retirement readiness.
Step 1: Develop a robust financial plan
The first is to develop a robust financial plan.
I have learned that many people believe their financial advisor has provided them with a financial plan for retirement when, in truth, the person they are dealing with is often more interested in providing investments.
A true retirement plan can only be assembled once you sit down with a professional advisor and talk about what you (and your spouse/partner) want to do, when you want to retire, where you want to live, and how much you think it will cost monthly, after-tax, in today’s dollars to accomplish this
Step 2: Take advantage of retirement savings vehicles
The second step you can take to gain greater confidence about your retirement readiness is to take advantage of retirement savings vehicles to your maximum ability. For many business owners, this means utilizing an IPP rather than the standard RRSP meant for Canadians at lower income levels.
Taking responsibility for your personal retirement needs
Governments continue to remind us, implicitly or otherwise, to rely less on the public purse and start taking personal responsibility when it comes to retirement and needs like assisted living and special care workers. These costs are necessary and can be expensive over time.
If you’ve worked hard as a professional or business owner, you owe it to yourself and your family to ensure you’ve done all you can to save for your future. Contact us to determine whether the IPP is a viable retirement savings vehicle for you. The best way to achieve financial peace of mind is by getting advice from an impartial and experienced Certified Financial Planner.