A specialist in his field of medicine, Victor knows his family is unlikely to ever want financially. He makes $280,000 a year before tax, some of which he saves in his professional corporation for retirement. His wife Vivian makes $85,535 a year working as a therapist. As such, she is part of a defined benefit pension plan indexed to inflation. They are both age 36 and are expecting their first child in a couple of months.
The couple’s lifestyle is modest, with their single largest expense being the $36,000 a year they give to help support parents. Their expenses will rise after the baby is born.
They prefer renting to owning a home because it is easier. “We prefer to live a simpler, completely debt-free life,” Victor writes in an e-mail. “After doing a detailed rent versus buy analysis in Toronto, we decided that renting and being good savers will put us ahead financially – and save us a lot of homeowner headaches,” Victor adds. He takes a keen interest in money and finances, and manages their investments himself using low-cost exchange-traded funds.
When she started working full time rather than on contract, Vivian’s employer gave her the option of “buying back” nearly three years of service toward her pension entitlement – earned during her time on contract – at a cost of about $31,000. Doing so would give her an extra $340 a month from the age of 60 on, indexed, plus $80 a month from age 60 to 65 for the bridge benefit, which ceases at the age of 65.
“I really don’t know how to analyze this to see if it makes sense,” Victor writes. “Thirty-one thousand is a lot to put in, but I can see with our current plan and the financial crisis, we would truly be in a terrible situation if in the year of our planned retirement, our liquid assets dropped as much as they did in February and March.”
We asked Ross McShane, vice-president, financial planning, at Doherty & Associates in Ottawa, to look at Victor and Vivian’s situation.
What the expert says
“It’s hard to turn down an offer to buy more years of service in a defined benefit pension plan like Vivian’s that is on solid footing and provides an indexed stream of income,” Mr. McShane says. Before they make the decision, a few things need to be considered.
“Could they invest the $31,000 and generate an income stream through retirement that would be equal to or greater than the additional pension income?” If they invest in stock markets, the return – unlike the pension – would not be guaranteed. If they invest in a fixed-income product, it’s unlikely they could equal what the pension would provide given today’s low interest rate environment.
Because Victor and Vivian are accumulating substantial savings, most of which are in equities, “I vote in favour of buying the additional years of pension because the pension can serve as the fixed-income part of their portfolio in retirement,” Mr. McShane says.
The trick is navigating complicated pension regulations to figure out how best to pay for the buyback. Generally, a person can use cash to buy back some years of pension entitlement, claiming a pension deduction on their tax return, much like an RRSP contribution. Alternatively, they could transfer funds from a registered retirement savings plan to their pension plan.
Buying back pension entitlement will affect Vivian’s pension adjustment, the amount she is entitled to contribute to an RRSP. (According to the Canada Revenue Agency, RRSP contribution maximums are used to set a fair level of tax-sheltered benefits for all taxpayers. Hence pension plan contributions reduce RRSP contribution room.)
In Vivian’s case, she cannot fund the buyback entirely with $31,000 in cash because her available RRSP room is only $20,624. So she will have to use some combination of cash and RRSP transfer, which entails selling some of the securities in her RRSP to raise cash in that registered plan to transfer to the pension plan.
One hitch is that Vivian and Victor are reluctant to sell the ETFs in her RRSP and transfer the funds to her pension plan because the ETFs are down. “The longer Vivian waits, the larger the cost of the buyback,” Mr. McShane says. “At the same time, Vivian would prefer to hold off transferring her RRSP funds until stock markets recover further.”
To get around this concern, they could consider the following: Vivian uses some combination of her RRSP funds and cash to buy back the pension years. Victor, meanwhile, has what is known as a “due to shareholder” balance in his corporate account of $43,000, which he can withdraw tax-free. He takes an amount of money equivalent to the value of the ETFs and deposits it in his own RRSP, investing in the same ETFs that Vivian sells. “The result is that as a family they would still hold the same amount in the ETFs in a registered plan,” Mr. McShane says.
While Victor and Vivian are unlikely to have any problems achieving their retirement goals, Victor may want to review his remuneration strategy at some point, the planner says. At the rate he is saving in his professional corporation, he will be in a situation within the next few years where his annual investment income (passive income) surpasses $50,000. For tax years after 2018, the tax rules have been changed to reduce the small business deduction when passive income exceeds this threshold.
Victor’s corporate net income after tax is about $180,000 a year. Of this, he draws $60,000 in dividends and leaves $120,000 in the corporation as retained earnings. At the personal level, he earns, before tax, another $54,000 a year teaching as well as about $5,000 a year consulting.
To slow down the passive income growth, Victor might want to consider drawing more of his annual earnings out of the corporation and retaining less. The additional draw could be in the form of salary or dividends, or a combination of both.
Alternatively, he could examine some other strategies – each with its pros and cons – including setting up an individual pension plan or even buying permanent insurance owned by the corporation to shelter some of the investment income from tax. The policy could be structured to pay a lump sum to the corporation upon Victor’s death that would then be distributed to his beneficiaries.
The people: Victor and Vivian, both 36
The problem: Should Vivian take advantage of the opportunity to buy back nearly three years of pension entitlement at a cost of $31,000? If so, how should she pay for it?
The plan: Buy back the pension through a combination of cash and RRSP transfer. If she’s reluctant to sell the ETFs in her RRSP while they are down, Victor could take some tax-free money from his corporation to buy the same ETFs for his RRSP.
The payoff: A pension that will serve as the fixed-income portion of their portfolio when they retire.
Monthly net income: $13,700 (excludes retained earnings).
Assets: His TFSA $68,120; her TFSA $24,480; cash $13,195; his RRSP $41,375; her RRSP $23,380; corporate investment assets $505,960. Total: $676,510
Monthly outlays: Rent $2,350; home insurance $25; utilities $80; food $500; clothing $50; cable, cellphones $90; entertainment, dining $150; hobbies, activities $175; life insurance $425; donations, gifts $120; travel $350; transportation $640; help for parents $3,000; miscellaneous $125; RRSPs $2,100; pension plan contribution $570; TFSAs $1,000. Total: $11,750. Surplus: $1,950
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Some details may be changed to protect the privacy of the persons profiled.
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