Generating healthy tax savings...And peace of mind throughout retirement

Eliza is a determined saver who maximizes her RRSP contributions every year and is looking for additional opportunities for tax-deferred growth. At 47, she is anxious to build a larger nest egg because she knows that, when she retires, she will be facing potential long-term care costs for her parents, one of whom experienced a stroke two years ago, and education expenses for her three children, who are currently 13, 11 and 9.

Both Eliza and her husband, Grant, own an incorporated consulting company. Eliza is in charge of new business development with a comfortable annual salary of $110,000. When she discussed her concerns about boosting her retirement savings with her financial advisor, he recommended that she (and possibly Grant) consider starting up Individual Pension Plans (IPPs).

IPPs are an attractive alternative to RRSPs for the right investor, and their popularity is on the upswing. Already accounting for nearly 35 per cent of the 19,000 private pension plans in Canada, this type of defined benefit pension plan is expected to double its numbers in the next three years. Without a doubt, IPPs are an option that should be considered for anyone who, like Eliza, has maxed out their RRSP contributions, or is looking for an option that provides significant tax advantages and potentially higher pension benefits.

There are several reasons Eliza's advisor suggested an IPP. Perhaps most important, for people over 40, IPPs offer higher tax-deferred contributions than RRSPs. Furthermore, any surplus in the plan belongs to her. This is an advantage IPPs have over other pension plans: any surplus stays in the fund and is used by the company to pay for benefits for other members of the plan.

That said, Eliza's advisor took the time to explain that an IPP requires the services of experts and is therefore associated with higher fees than a self-directed RRSP – covering everything from set-up to ongoing administration, actuarial services and trustee services. In most provinces, an IPP is registered with the provincial pension authorities, and they also require annual fees. In addition, except in Saskatchewan and Quebec, pension legislation requires that the assets be locked in. This means there is generally no access to the funds in the plan until retirement – and even then Eliza will only be able to withdraw an income stream.

Nonetheless, for many people the advantages offered by IPPs far outweigh the disadvantages. And the qualifications aren't difficult to meet. Specifically, to hold an IPP, you must:

• Have employment income reported on a T4;
• Be an employee of an incorporated company; and
• Be age 40 or older and ideally earn an income of at least $100,000 from the company sponsoring the IPP.

Eliza will benefit immediately from changes announced in the 2003 federal budget, where the Government of Canada increased the maximum pension limits to $2,000 per year of service. As well, the 2005 federal budget proposed continuing increases of approximately 5.5 per cent per year to the $2,000 limit, with increases based on the Industrial Average Wage beginning in 2011.

When Eliza turns 50, her annual maximum contribution will be more than $6,000 higher than the maximum contribution she could make to an RRSP. It's important to note that as she gets closer to retirement, the cost to provide the benefit increases. She can also include service dating back to 1991. This is optional, but if Eliza decides to include extra years, it will significantly increase the amount that she can deposit into the plan.

Contribution rules
For Eliza, or anyone else, IPP contributions are established through an actuarial valuation of the plan. Contributions can be broken down into the following three categories:

• Current & Future Service Contributions – These contributions are made to pay for the value of benefits being earned each year after the implementation of the plan.
• Past Service Contributions – These contributions are made to pay for benefits earned in prior years.
• Terminal Funding Contribution – This type of contribution is only available at the actual retirement date or pension commencement date. This is most commonly used to provide early retirement enhancements at age 60.

In an RRSP, the maximum contribution for 2005, regardless of age, is 18 per cent of 2004 earned income up to a maximum of $16,500. On the other hand, IPP contribution amounts increase with age – so the older you get, the greater the advantage you will experience over an RRSP. At 50, Eliza can contribute 22.7 per cent of her T4 earnings; at 55, she can contribute 25 per cent; and at 60, she can contribute 27.4 per cent.

Investment choices
If Eliza decides to go the IPP route, she will generally have the same investment options as she did in her selfdirected RRSP.

Eliza's IPP assets can be invested in:

• Stocks
• Bonds
• Mutual funds
• Segregated funds
• Principal protected notes (PPNs)
• Term deposits
• GICs

In Eliza's case, her advisor explains that he will target the prescribed rate of return for IPPs of 7.5 per cent each year within a balanced portfolio. He tells her that if, for any reason, the IPP does not achieve its 7.5 per cent return in a given year, her company can make up the difference with additional tax-deductible contributions. In fact, to maximize contributions, some advisors concentrate IPP assets in relatively conservative investments with the express intention of missing the 7.5 per cent target, while investing more aggressively outside the IPP.

All in all, IPPs offer the potential for additional taxdeferred growth to investors like Eliza, along with investment flexibility and a secure source of retirement income. Because the rules – including locking-in rules – can be complicated, be sure you and your advisor discuss all the consequences of shifting your retirement savings strategy to an IPP. Of course, your advisor can also help you determine if this is the best approach for you to take based on your specific circumstances, and recommend appropriate investments for your plan.

IPPS and the family business
Jason runs a family business with his wife, Karen, and their son, Peter. Normally, on the death of the second spouse, registered assets create a tax liability in the estate. In other words, after Jason and Karen pass away, their RRSPs cannot be transferred tax-free to Peter. But an IPP is an ideal way to keep the assets in a tax-deferred vehicle when a family business is part of the equation.

In this case, the business will continue to operate after Jason and Karen retire, so they can add Peter as a member of their existing IPP. By leaving the plan intact, any assets not used to provide benefits to the retired couple will remain and "transfer" to the second generation without triggering tax.

IPPs can benefit families who decide to sell their company, too. Most small businesses are sold to family members or partners. The proceeds from these types of asset sales are treated as taxable income. By setting up an IPP now using terminal funding, a deduction can be created against this income.

Talk to your financial advisor for more information about these family business strategies.

Tip
If you want to make past service contributions to an IPP, they do not have to match the contributions you have actually made to an RRSP or another pension plan. Furthermore, they can come from any RRSP. For example, if you were in a pension plan before and left that company when you started your own business, you may have money in a locked-in RRSP. Alternatively, you may have been in a defined contribution pension plan along with other employees. When you set up your IPP, you can move the other pension assets into it. This strategy enables you to use money that has already been locked in to fund past service contributions.

KNOW THE FACTS

IPP Advantages	IPP Disadvantages
Employees over age 50 enjoy an annual maximum contribution that is at least $6,000 higher than the maximum contribution for an RRSP.	Unlike RRSPs, pension plans do not allow for income splitting – you cannot make spousal contributions to a pension plan.
When an IPP is established, past service contributions enable you to catch up for the previous years you worked for the company. Past service contributions are calculated on each of your year's annual earnings going back to the company's creation, the date you started working for the company, or January 1, 1991, whichever is most recent. For companies with excess cash, this is a great opportunity to move it from the company to a tax-sheltered IPP. For companies without surplus cash, past service obligations can be amortized up to 15 years.	Initial set-up fees* can be as much as $3,000, and will increase if past service benefits are provided. Annual expenses and filing fees after the first year will average $1,000 or more, including an actuarial report every third year.
Guaranteed lifetime income – the IPP offers a predictable retirement income. An actuary determines the annual contributions required.	Any surplus that is not required to pay for the promised benefits is paid to the member in a lump sum and is fully taxable.
Pension benefits are protected from creditors under pension legislation, unlike most RRSPs.	Funds are locked-in (including any RRSPs transferred to purchase past service), meaning there is limited flexibility with respect to accessing cash.
IPP contributions and expenses are fully tax deductible to the business. If the company borrows money or amortizes the past service cost, the interest charges are also deductible.	Personal RRSP contribution limits are reduced considerably with an IPP.

* Set-up fees include preparation of the plan, registration with Canada Revenue Agency (CRA) and the provincial regulator, and the initial valuation. These cost may vary depending on the actuarial firm.