Budget helps retirees

There’s good news in Budget 2014 for people on the verge of retirement. Employees planning to commute underfunded pensions will get a tax break.

“[It] allows individuals receiving reduced payouts from their pension plans to transfer larger portions to locked-in RRSPs, for instance, on a tax-deferred basis,” says Wilmot George, director, Tax and Estate Planning at Mackenzie Investments.

Clients will now receive cash payouts from their employers that reflect the lump-sum values of their pension benefits.

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How does it work? David Ablett, director, Tax and Retirement Planning at Investors Group provides this hypothetical scenario.

Say a client is leaving his company and has a pension benefit with a commuted value of $500,000. The Income Tax Act provides a formula that determines how much of the commuted value can be rolled into a locked-in registered account.

In this case, the client’s maximum transfer value is $400,000. So there’s $100,000 in excess payments to be made by the employer.

“We also assume the plan’s solvency ratio is 80%, which means the plan is 20% underfunded. In that situation, many jurisdictions will say the pension plan can only pay out 80% immediately,” says Ablett. “The remaining 20% will be paid to the individual over the next five years.”

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He adds, “If the pension plan is underfunded, the employer is required to put extra payments into the plan over five years to bring the plan back up to fully funded status. So the employee may have to wait up to five years to receive all the pension benefits he’s entitled to.”

Under existing rules, the maximum transfer value would be prorated. In this case, $320,000 of the initial $400,000 would be transferrable into a locked-in account. The remaining $80,000 is a cash payment.

And of the $100,000 that was underfunded, $80,000 would be transferred into the locked-in account, and $20,000 paid in cash over five years.

But under the new rules, explains Ablett, the initial maximum value of $400,000 continues to apply and it can all be rolled out immediately. So the client can shelter an additional $80,000 into the locked-in account right away. The remaining $100,000 would be paid in cash within the next five years.

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Ablett adds the new rule might make the commuted value option more attractive for clients because, “on the surface, there’s more money available to roll over into a locked-in account right away, on a tax-sheltered basis.”

But, he warns, if clients are considering this option they still must do a detailed analysis.

“By taking the commuted value, you’re giving up the right to a guaranteed lifetime pension, which will not change over time. So you’re assuming the investment risk.”

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He suggests helping clients determine what rate of return they’d have to generate to provide the same type of retirement income that the pension plan would’ve provided.

“Recognize that the pension allowance won’t change over time, but the amount you could receive under the transfer option will be dependent on your long-term investment performance.”

The new rule is an extension of one announced in 2011, and only applies to defined benefit plans. The budget estimates these changes will reduce federal revenues by $3 million in 2013 to 2014, and by $5 million for the following two tax years.