This article was written by Monica Townson and reproduced
from Money Magazine November/December, 2001.
Let’s
say you’re a successful entrepreneur or the owner/manager of a small business,
in your 50s, give or take a few years.
Sales are booming, but it’s just hit you that you have nothing put away
for your retirement. You’ve been far
too busy building up the business to even give it a thought.
Would it surprise you to learn that five years from now you could have a substantial retirement fund, built up with tax-deductible contributions, waiting to provide you with a nice pension when you call it quits? No, it's not an RRSP. With current contribution limits of $13,500 a year, there's no way. It's called a retirement compensation arrangement (RCA).
Major corporations use RCAs to boost the pensions of executives and senior employees. And now small business owners are finding them a tax-effective way of building up a healthy retirement nest egg in a relatively short time—particularly if they've been paying out substantial bonuses to keep their corporate earnings low enough to qualify for the preferential small business tax rate. For the high-income self-employed, an RCA helps level the field against what you might have received as a corporate executive with a comparable salary and a generous pension plan.
The pension benefit
It’s not easy, though, to compare the kind of pension a self-employed owner/manager can accumulate with what an equivalent salaried manager or executive might get. Even major corporations can’t pay out unlimited tax-assisted benefits through their pension plans. Tax rules— which haven't changed in 25 years—limit how much pension you can accumulate under a registered defined benefit (DB) plan to $1,722.22 for each year of service, up to a maximum of 35 years.
That
provides a pension worth about 70 per cent of $86,000 a year, which when the
law was written would have been the pre-retirement income of a fairly senior
executive. But these days even middle
managers make more than that, which is why many corporations now use
supplementary retirement plans to boost the pensions of senior employees who
would otherwise get a maximum pension of only about $60,000 a year.
Most companies use a supplemental employee retirement plan (SERF) — typically an unfunded arrangement under which the employer agrees to pay additional benefits to top up what the employee will get as a company pension.
Together with benefits from the company plan, a SERF may bring an employees retirement income up to 70 per cent of his or her average earnings over the last five years of service. But it's important to note that if there's no fund, this arrangement may not be guaranteed — especially if control of the company changes hands or if it goes bankrupt. That's one reason some companies are now using RCAs to fund pension supplements.
Unlike
an RRSP, there's no statutory limit on the amount that can be contributed to an
RCA, and it's not subject to pension rules, either. What's more, a company can
even claim a tax deduction for the full amount contributed to a plan on your
behalf. And because the assets in the plan are held in trust, they're safe from
a company's creditors.
There are some wrinkles you should know about, however. The Income Tax Act sets the rules for these supplemental pension plans, one of which is that half of everything paid into a plan has to go into a refundable tax account held by the Canada Customs and Revenue Agency (CCRA), on which no interest is paid.
The other half must be held in a trust fund and administered by your trustee — a financial adviser, accountant, financial institution or even a small company you set up specifically for the task. The trustee invests the funds under the rules of the trust and reports annually to the CCRA. As a result of this arrangement, only half the money contributed to an RCA will generate investment returns.
And half of those returns must also go into the refundable tax account. There's a way to soften that blow. Ron Schreider, senior marketing director of Assante Estate and Insurance Services in Toronto, explains that if the RCA trust uses life insurance as an investment, you can avoid having to transfer investment earnings to the refundable tax account. It costs more to set up this kind of plan, though, and Donna Cappon, VP and managing director, trust services, at BMO Harris Private Banking in Toronto, estimates that it could be 10 to 13 years before the advantages of the tax-free accumulation outweigh that additional cost. When you start taking the money out of an RCA at retirement, the CCRA will pay out $1 from the refundable tax account for each $2 withdrawn from the trust account. And you'll have to declare the funds as income for tax purposes.
Being reasonable
While the possibilities of an RCA may seem endless, Jim Sheldon, a financial adviser with Assante Capital Management in Toronto, explains that the arrangement must be "reasonable" in the eyes of the tax authorities. That's why funding for an RCA is generally based on actuarial projections, in the same way as a defined benefit pension plan. For instance, contributions may be set to build up a fund that will generate a pension of 70 per cent of the owner/ manager's earnings over his or her best five years.
If your company puts so much money into your RCA that the resulting pension will bear no relation to your pre-retirement earnings, the CCRA could decide it's a "salary deferral arrangement"—a way of postponing some of your salary and reducing your current tax liability. And if that happens, you'll get taxed on the amount of the contribution at your top rate.
"The shorter the time the funds are in the RCA," says Sheldon, "the more efficient its use." That's because you're only earning a return on half your investment. But if you're thinking of selling your business within five years, for instance, or perhaps passing it on to the next generation, now's the time to start planning an RCA.
Speedy delivery
And it can work that quickly. As Cappon explains, instead of paying you a bonus each year, your company could contribute the amount to an RCA instead — an attractive option when you consider that the CCRA will tax your bonus at your top marginal rate. An annual contribution of $300,000 for the next five years for example, would give you $1.5 million in the RCA, which Cappon believes is about what you'd need to provide yourself with a respectable pension income.
If you have more socked away, so much the better. Some small-business owners have as much as $7 million in an RCA, she says. As long as the amount is based on actuarial calculations that take into account your current income, lifestyle and so on, it should meet the CCRA's test of being reasonable. What counts is the amount of retirement income the RCA is designed to provide, not the length of time in which the funds are accumulated.
Schreider says it can cost anywhere from $7,000 to $60,000 to set up an RCA. One-time legal fees to draw up the trust agreement add perhaps another $1,000 to $5,000. Annual trustee fees can range from $1,250 to $8,000 or more. There are also some accounting fees and other related costs.
In spite of all the conditions attached, Cappon believes RCAs have many bene fits for entrepreneurs and owner/managers. You can set aside funds when your business is doing well, and give yourself some security if the lean years come along. And if you have key employees you want to hold on to, an RCA may help keep them on board — especially if your company is a likely merger or acquisition target.
One added advantage: Many banks are willing to lend against RCA assets, including the refundable tax balance. Cappon warns, however, that this would have to be set up carefully to stay onside with CCRA rules.
Last but not
least, you may enjoy some tax savings when you retire because you can extend
the tax deferral on other savings by drawing on your RCA first and not cashing
in your RRSPs right away.
Other
articles included this month:
RRSPs Still a Foreign Investment to Many
Return to Jan-Feb 2002 $$$ Maker Report