Defined contribution plans have become popular within the private sector in Canada over recent years. While the specifics of each plan may vary from employer to employer, in this article we will discuss common features of defined contribution plans, how they differ from defined benefit plans as well as, some common plan types.
Defined contribution plans are retirement savings accounts that are typically arrangements between an employer and employee. Both the employer and employee contribute a set amount to the account with the intentions of funding retirement income. Shared contribution arrangements between the employer and employee are common. For example, with a matched contribution plan, the employee contribution limit may be 7% of gross earnings and the employer will match whatever the employee contributes up to that amount.
The funds in an employee’s account have the ability to increase over time based on investment returns. Unlike a defined benefit plan, the employee decides on the investments within their account, therefore the employee takes on the investment risk rather than the employer.
If you have been a member of the Canadian workforce for a number of years, you may already belong to either a defined contribution or defined benefit plan. While both can be tax-efficient ways to save for retirement, they also have their distinctions. As mentioned earlier, the employer takes on the investment risk in a defined benefit plan, whereas the employee takes on the investment risk in a defined contribution plan.
In a defined benefit plan, employers are generally responsible for making contributions to the employee’s retirement fund which is invested at the direction of the plan sponsor. In a defined contribution plan, the employee and often the employer make contributions to the retirement fund and the employee determines how the funds are invested.
Since your employer is responsible for contributions in a defined benefit plan there is no annual contribution limit. Compared to defined contribution plans, which generally have limits on how much you can contribute.
One popular form of defined contribution plan in Canada is the Registered Retirement Savings Plan (RRSP). These are government-assisted retirement savings plans often offered by banks and insurance companies. You may find these plans advantageous given their favorable tax treatment. Contributions, interest and capital gains are all tax exempt until withdrawal.
RRSP investors can contribute up to 18% of their annual earnings. In 2019, the maximum annual contribution an investor can contribute to their RRSP is $26,500.[i] Plan members that are still working have the ability to contribute to a RRSP until the age of 71. Once a plan member turns 71, their funds generally convert into an annuity where they are distributed on an annual basis based on the minimal withdrawal schedule. RRSP investors have the ability to withdraw from their account prior to 71 but are required to pay income taxes on the amount withdrawn.
The Government of Canada may also provide opportunities for RRSP investors who are looking to purchase their first home or fund their own education. The Home Buyers Plan and the Lifelong Learning Plan allows investors to withdraw their money without paying income taxes. Investors have 15 years to pay pack the withdrawn funds, otherwise it will be considered taxable income.[ii]
Money-Purchase Pension Plan – Money-purchase pension plans are typically funded with fixed contributions and converted into a lifetime annuity among retirement. Each plan member’s pension value varies based on their contributions and their investment returns within their account.
Locked-In Retirement Account (LIRA) – Funds within a LIRA account are—as the name suggests—locked in until retirement. Contributions from these accounts typically come from old pension funds from a former plan member, spouse or surviving partner until they turn 71. Most LIRA investors have an objective of providing income for life. This often leads them to transferring the LIRA funds into a Life Income Fund or a Locked-Retirement Fund.
Understanding the nuances of these different account types can be difficult. Even once you start to understand the distinctions between these accounts, the contribution rates change on a regular basis making it difficult to keep up. If you would like to learn more about the details of your accounts or what to do next with your funds, Fisher Investments Canada can help. Reach out and speak with one of our qualified professionals today.
[i] Source: Government of Canada, as of 6/18/19. www.canada.ca/en/revenue-agency/services/tax/registered-plans-administrators/pspa/mp-rrsp-dpsp-tfsa-limits-ympe.html