Commuting your pension and taking the commuted value as a lump sum offers flexibility and control over your retirement funds. However, it can also lead to significant tax liabilities if not handled carefully. Fortunately, there are ways to commute your pension without triggering heavy taxes. In this article, we’ll explore the strategies that can help you minimize taxes when commuting your pension and ensure you retain as much of your retirement savings as possible.
What Does It Mean to Commute a Pension?
To commute your pension means converting your future pension payments into a lump sum, called the commuted value. This allows you to take control of your retirement savings by transferring them to a tax-sheltered account, such as a locked-in retirement account (LIRA) or registered retirement savings plan (RRSP), or by investing them in other financial products.
The commuted value is the present value of all the future payments you would have received from the pension plan. This calculation takes into account factors like your age, life expectancy, and current interest rates. When you commute your pension, you receive a lump sum, which gives you more control over how the money is used, but it also comes with potential tax implications.
The Tax Implications of Commuting a Pension
When you commute your pension, one of the biggest challenges is managing the tax implications. The Canada Revenue Agency (CRA) has strict rules about how much of your commuted value can be transferred tax-sheltered into registered accounts. The portion that exceeds this limit will be taxed as regular income, which could result in a large tax bill.
Maximum Transfer Value
The CRA sets a limit on how much of your commuted value can be transferred into tax-sheltered accounts like an RRSP or LIRA. This limit is known as the maximum transfer value. The portion of your commuted value that is within the maximum transfer value can be transferred tax-free, but any amount that exceeds this limit will be paid to you in cash and taxed as income in the year you receive it.
For example, if your commuted value is $500,000 and the maximum transfer value is $350,000, the remaining $150,000 must be taken as a taxable lump sum. Depending on your tax bracket, this could push you into the highest tax bracket and result in a substantial tax bill.
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How to Minimize Taxes When Commuting Your Pension
Fortunately, there are several strategies you can use to minimize the taxes you’ll pay when commuting your pension. By planning carefully and using the right tools, you can reduce the impact of taxes and keep more of your hard-earned retirement savings.
1. Use RRSP Contribution Room
One of the most effective ways to reduce taxes when commuting your pension is to take advantage of any unused RRSP contribution room you may have. By contributing the taxable portion of the commuted value to your RRSP, you can offset the taxes you would otherwise owe on that amount.
For example, if you have $50,000 in unused RRSP contribution room and your commuted value exceeds the maximum transfer value by $50,000, you can contribute the extra $50,000 to your RRSP. This will allow you to defer taxes on that amount, effectively reducing your tax liability for the year.
Make sure to check your latest Notice of Assessment [NOA] from the Canada Revenue Agency or your financial advisor to confirm how much RRSP contribution room you have available before commuting your pension.
Some employers allow the surplus to be direct transfered to your RRSP. This is the simplest way. Other employers refuse so you’ll need to deposit money to your RRSP after receiving the lump sum cash. Then top up with other available cash OR line of credit.
Why not borrow to pay into your RRSP? Your borrowing cost might be 1/2% a month for a few month. Your saving on taxes could be 30% or more. Top up your RRSP when your annual income is the highest.
2. Timing your departure
Here’s a scenario. Let’s say Rob retires in September. His commuted value is settled in December. Therefore, his cash surplus which is taxable arrives in the same tax year, i.e. calender year, as his income. So his gross income for the year is unusually high.
Bill retires in October. He receives his final pension statement in November BUT he has 60 days to respond. Bill submits his signed docs on January 1st. Bill receives his cash surplus in February. Therefore, this income does NOT bump Bill into a high tax bracket. Voila.
3. Split the Income with Your Spouse
If you’re over the age of 65, you may be eligible for pension income splitting, which allows you to allocate up to 50% of your eligible pension income to your spouse or common-law partner. This can reduce your overall family tax burden, if your spouse is in a lower tax bracket.
Pension income splitting applies to certain types of retirement income, including payout annuities purchased with pension funds. If you commute your pension and transfer the funds into an annuity, you may be able to split the income from the annuity with your spouse, reducing the amount of income subject to tax in your name.
This strategy can help you keep more of your pension income and potentially avoid being pushed into a higher tax bracket.
4. Consider Phased Retirement Withdrawals
Another way to reduce the tax impact of commuting your pension is to consider a phased approach to withdrawing your retirement savings. Instead of taking the entire commuted value as a lump sum, you can transfer the funds into a life income fund (LIF), registered retirement income fund (RRIF), or another registered account and withdraw the money gradually over time.
By spreading out the withdrawals, you can keep your taxable income lower each year, avoiding a large tax hit in any single year. This approach also allows your investments to continue growing tax-deferred within the registered account, giving you more time to build your retirement savings.
5. Purchase a Copycat Annuity
A copycat annuity is an annuity designed to mimic the payments you would have received from your defined-benefit pension plan. When you commute your pension, you can use the commuted value to purchase an annuity from an insurance company that provides the same or similar guaranteed monthly income. We quarterback this process for you. You don’t pay. The insurance company pays us.
One of the advantages of purchasing an annuity with your commuted value is that you can spread out the payments over your lifetime, reducing the immediate tax burden. Annuity payments are typically treated as regular income and taxed as such, but since the payments are spread out, the total tax impact is lower than taking the entire commuted value as a lump sum.
And, there is most often a cash surplus. The insurance company, say Manulife or Sun or Desjardins, don’t need all the commuted value to offer you the copycat pension. You get the difference in pocket.
Additionally, annuities are eligible for pension income splitting, which can further reduce your tax liability if you’re married or have a common-law partner.
5. Plan for Taxes Ahead of Time
One of the most important steps you can take to avoid heavy taxes when commuting your pension is to plan ahead. Working with a financial advisor or tax professional can help you create a strategy for commuting your pension that minimizes taxes and maximizes your retirement savings.
Consider factors like your RRSP contribution room, the availability of pension income splitting, and your expected tax bracket in retirement. By planning ahead, you can make sure that your pension commute is done in the most tax-efficient way possible.
When Should You Consider Commuting Your Pension?
Commuting your pension is a significant decision, and it’s not the right choice for everyone. However, there are certain situations where commuting your pension may make sense:
You Want More Control Over Your Retirement Savings
If you’re confident in your ability to manage your own retirement savings, commuting your pension can give you more control over how your money is invested and withdrawn. This can be particularly appealing if you have experience managing investments or if you want the flexibility to access larger sums of money in retirement.
You Have a Shorter Life Expectancy
If you expect to have a shorter life expectancy due to health issues, commuting your pension might make sense. Taking the commuted value allows you to use the money for other purposes, such as medical expenses, or pass it on to your heirs, rather than relying on a monthly pension that may not fully benefit you.
You Want to Leave an Inheritance
If leaving an inheritance for your loved ones is important to you, commuting your pension gives you more control over what happens to the remaining funds after your death. With a defined-benefit pension plan, payments typically stop when you and your spouse pass away, unless there are specific survivor benefits. By taking the commuted value, you can pass on any remaining funds to your heirs.
You Want Flexibility
If you need flexibility in your retirement planning—whether it’s for large expenses, travel, or business ventures—commuting your pension provides the freedom to use the money as you see fit. This flexibility can be appealing for retirees who want to take a more active role in managing their finances.
When is it Better to Leave Your Pension in Place?
While commuting your pension offers flexibility and control, there are times when it’s better to leave your pension in place and receive monthly payments:
- You Want Guaranteed Income: If you prefer the security of knowing you’ll receive a steady, guaranteed monthly income for life, leaving your pension in place is the safest option.
- You Don’t Want Investment Risk: Managing the commuted value means taking on the risk of investment performance. If you’re not comfortable with this risk or don’t want to manage your own investments, sticking with the pension is a better choice.
- You Expect to Live a Long Life: If you have a long life expectancy, the guaranteed income from a pension can provide peace of mind, knowing that you won’t outlive your retirement savings.
Final Thoughts on Commuting a Pension Without Heavy Taxes
Commuting your pension offers flexibility and the potential for higher returns, but it also comes with tax challenges that need to be carefully managed. By using strategies like maximizing your RRSP contribution room, taking advantage of pension income splitting, and gradually withdrawing your funds, you can minimize the tax burden and keep more of your retirement savings.
It’s important to consider your personal financial situation, health, and retirement goals before deciding whether to commute your pension. Working with a financial advisor can help you create a tax-efficient plan for commuting your pension and ensure you make the most of your retirement savings.
