RCA's - Should You Take Another Look?

Canada has a system for tax assisted retirement savings which is designed for people earning less than $90,000 per year. The tax assisted plans (i.e. RRSP's and Registered Pension Plans) have limits on tax deductible contributions and, in the case of some types of RRSP's, limitations on the amount of pension income which can be paid out. RRSP's and RPP's also have specific rules governing the types of investments which may be made in order for the plans to remain registered and retain their tax status. Nevertheless, contribution to RPP's and RRSP's can be tax deductible and income earned inside these plans is sheltered from current income tax.

In the case of owners/managers of privet companies, the tax system is structured so that annual bonuses may be necessary to reduce the company's taxable income to $200,000 or less. If the bonus is subject to the highest marginal rate of tax in BC of 54%, the owner/manager only has 46% left to invest. Similarly, investment income may be taxed at a rate of up to 54% depending on the nature of the investment. Again, the owner/manager only has the after tax amount left to invest.

An Alternative

One alternative to accumulate retirement funds in a more efficient manner is to set up a non-registered pension arrangement which is taxed as retirement compensation arrangement (RCA). This type of plan is designed to benefit owners/managers of private companies, senior executives of public companies and high income professionals. An RCA might work as follows:

• Annual contributions are made to plan by company.
• The annual contribution can be a fixed amount or a flexible amount based on a formula or annual allocation.
• The annual contribution is placed in trust to provide for the plan member's retirement benefit.
• A simple trust document is executed setting out the provisions.

How is the Plan Taxed?

The plan will be taxed as a retirement compensation arrangement (RCA). The tax rules can be summarized as follows:

• Contributions made to the company are tax deductible to the company.
• Payments out of the plan to the member are taxed as ordinary income. If the recipient is non-resident at the time the payment is received, the payment is subject to with-holding tax at 25%. That rate may be modified by treaty.
• 50% of any contributions made to the plan by the company are remitted to Revenue Canada as refundable tax.
• 50% of any taxable income in the plan is remitted to Revenue Canada as refundable tax.. This income would include realized capital gains and dividends.
• The refundable tax. is recovered by the trust as payments are made to the member. A dollar of refundable tax is recovered for every two dollars paid to the member.

Investments

As an RCA is not a registered plan, there are no statutory restrictions on the investments that may be made. However, because all taxable income is subject to the 50% refundable tax, investments that provide a full or partial tax shelter can provide higher long-lasting accumulation. Life insurance policies are typically used to shelter the investment income. The pure death benefit element of the insurance policy can be owned outside of the ECA arrangement under a shared ownership agreement. This leaves the investment within the plan accumulating on a fully tax sheltered basis.

Principal Benefit

The principal benefit of an RCA style arrangement may be in situations where the payments out of the RCA can be received at a lower tax rate than the individual's current marginal tax rate on salary or bonuses. In order to be tax effective, the RCA must be structured as pension arrangement. However, the arrangement can have a great deal of flexibility. If the individual will ultimately receive pension income at a lower tax rate, then the arrangement may be able to provide that individual with substantially higher after-tax retirement income.

The ability to shelter investment income from current income tax can also have a major affect on the amount of after-tax retirement income available later on. Again, this can be accomplished though either using a life insurance policy or by using investment funds with a low turnover.

The attached tables show comparisons between 3 alternatives as follows:

1. Deposits to an RCA that earn tax shelter investment income.
2. Deposits to an RCA that are invested in a taxable investment.
3. Receiving a bonus, paying the top rate of tax and reinvesting to provide retirement income.

The comparisons assume that the retirement income is received at different tax rates as follows:

• Table A - A rate equal to the top current marginal BC rate of 54%.
• Table B - A rate equal to an average income rate of 40% on retirement.
• Table C - A rate equal to 25% being the current with-holding tax rates on payments to non-residents.

As the tables show, the long-term benefits of an RCA arrangement, especially where the income is tax sheltered, can be substantial.

Table A: Income Comparison Assuming a 54% Tax Rate During Retirement.

Comparison assumes recipient is a male age 45 and annual contributions of $50,000 are made for 10 years. Annual income commencing at age 65 payable for 20 years.

Table B: Income Comparison Assuming A 40% Tax Rate During Retirement.

Comparison assumes recipient is a male age 45 and annual contributions of $50,000 are made for 10 years. Annual income commencing at age 65 payable for 20 years.

Table C: Income Comparison Assuming A 25% Tax Rate During Retirement

Comparison assumes recipient is a male age 45 and annual contributions of $50,000 are made for 10 years. Annual income commencing at age 65 payable for 20 years.

Retirement Compensation Arrangement

RCA Pension Trust Features: Creditor proof Does not affect RRSP or RPP contribution limits No statutory cap on contributions No cap on payout Taxes are refundable Potential lower tax rates on payout Can allow for maximization of RRSP and Pension Benefits Flexible