Leaving your job is a major life change, and if you’ve been contributing to a pension plan, it’s crucial to understand what happens next. The choices you make regarding your pension can significantly impact your retirement income. Whether you’re transitioning to a new job, retiring early, or simply moving on, you need a strategy for how to handle the pension benefits you’ve earned. Let’s explore how you can maximize the value of your pension when you leave your job.
What Happens to Your Pension When You Leave Your Job?
If you’re part of an employer pension plan, leaving your job doesn’t mean you lose what you’ve built up. The specific options available to you depend on the type of pension you have—whether it’s a defined-benefit pension plan or a defined-contribution plan.
In a defined-benefit pension plan, the benefit you’ll receive is based on a formula that includes your salary and years of service. When you leave your job, your options might include leaving the pension in place to receive a monthly payment upon retirement or taking the commuted value as a lump sum and transferring it to another retirement pension, a copycat annuity.
For a defined-contribution plan, the pension is based on the contributions made by both you and your employer, as well as the performance of your investments. When you leave the job, you can typically transfer the balance to a locked-in retirement account (LIRA) and / or RRSP / RRIF.
The decision you make can either protect your future retirement income or risk diminishing it. That’s why it’s so important to understand your options before making a move.
What is the Commuted Value of Your Pension?
The commuted value is the lump sum equivalent of your pension benefit. Essentially, it’s the current value of the lifetime pension payments you would receive. This value is calculated based on factors like your age, expected life expectancy, and interest rates.
When you take the commuted value, you’ll need to invest the money yourself to create your own retirement income. Many people choose to transfer the commuted value into a locked-in retirement account or another type of retirement account, where it can continue to grow until retirement.
There are pros and cons to taking the commuted value versus leaving your pension in place. The commuted value offers flexibility, but it also transfers the responsibility of managing your retirement income onto you. If you don’t manage it well, the money could run out.
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Should You Commute Your Pension or Leave It in Place?
The big question when you leave your job is whether to commute your pension or leave it in place. Each option has its advantages, and the best choice depends on your financial goals, health, and risk tolerance.
Reasons to Commute Your Pension:
- More control over investments: If you’re confident in your ability to manage investments, taking the commuted value allows you to potentially grow your retirement savings beyond what the pension plan would offer.
- Flexibility: You have more options with the money. You can invest in markets, real estate, or other assets, and decide when and how much to withdraw.
- Inheritance: By commuting your pension, you can pass on any remaining funds to your heirs, something that’s not always possible with a defined-benefit pension plan.
- Still working: Perhaps you’re ‘too young’ to quit working. You really don’t want to collect a pension and a salary, that would mean the salary is highly taxed. So, sit on the pension money and watch it grow while you feed your family from the lower taxed salary.
Reasons to Leave Your Pension in Place:
- Guaranteed income for life: One of the main benefits of leaving your pension in place is that you’ll receive a monthly income for life, no matter how long you live.
- No investment risk: With the pension plan managing the funds, you don’t have to worry about market fluctuations or running out of money.
- Less hassle: If you’re not comfortable managing your own retirement funds, leaving the pension in place is a simpler, more hands-off option.
It’s essential to carefully weigh these options before making a decision. If you’re unsure, it may be worth consulting a financial advisor who can help you evaluate the pros and cons in the context of your overall financial situation.
How to Transfer Your Pension to a Locked-In Retirement Account
If you decide to commute your pension, one of the most common options is to transfer the commuted value to a locked-in retirement account (LIRA). A LIRA works similarly to a registered retirement savings account (RRSP), but the money is “locked in” until you reach retirement age, ensuring it’s used for retirement purposes.
Transferring your pension to a LIRA has some key benefits:
- Tax-deferred growth: The funds in a LIRA grow tax-free, meaning you won’t pay taxes on investment gains until you start withdrawing the money in retirement.
- Flexibility: While the money is locked in, you have more control over how it’s invested. You can choose from a variety of investment options based on your risk tolerance and retirement goals.
- Retirement Income: Once you reach the minimum age for withdrawing from the LIRA (usually 55), you can convert it into a life income fund (LIF) or registered retirement income fund (RRIF), which will provide you with regular retirement income.
To transfer your pension to a LIRA, you’ll need to contact your pension plan administrator and follow their guidelines for completing the transfer. It’s important to ensure the transfer is done correctly to avoid triggering unnecessary taxes or penalties.
Should You Transfer Your Company Pension to a Copycat Annuity?
Another option to consider when leaving your job is transferring your company pension plan to a copycat annuity. A copycat annuity mimics the benefits of a defined-benefit pension plan but is purchased from an insurance company.
The main advantage of a copycat annuity is that it provides the same guaranteed monthly payments you would have received from your pension. However, it gives you the security of knowing your money is being managed by an insurance company rather than relying on the health of your employer’s pension plan.
This can be an attractive option if you’re concerned about the long-term viability of your company’s pension plan. The copycat annuity ensures that you continue to receive the pension income you were expecting, and it’s protected by Assuris, a non-profit organization that protects Canadian policyholders if their insurance company fails.
What Are the Tax Implications of Taking the Commuted Value?
If you decide to take the commuted value of your pension, it’s crucial to understand the tax implications. The Income Tax Act has rules on how much of your commuted value can be transferred tax-free into a registered account, such as a LIRA or RRSP.
The maximum transfer value is the most you can transfer without triggering immediate taxes. Any amount above this limit is paid out to you as cash and is subject to income tax in the year you receive it. Depending on the size of your commuted value, this could result in a significant tax bill.
To avoid unnecessary taxes, you’ll want to ensure you’re transferring as much as possible into a tax-sheltered account, like a LIRA or RRSP. If the commuted value exceeds the transfer limit, consider strategies like contributing to an RRSP if you have unused contribution room.
Can You Use Pension Income Splitting?
For those over the age of 65, one way to reduce the tax burden of your retirement income is through pension income splitting. This allows you to split up to 50% of your eligible pension income with your spouse or common-law partner. By shifting some of your income to your spouse, you may be able to reduce your overall family tax burden, especially if your spouse is in a lower tax bracket.
If you take the commuted value and invest it in a LIRA or RRSP, you may be able to eventually split the income from these accounts once they are converted into a retirement income vehicle, like a life income fund (LIF) or registered retirement income fund (RRIF).
This strategy can help you maximize the after-tax value of your retirement income, allowing you to keep more of your hard-earned savings.
What Happens if You Leave a Job with a Defined-Contribution Plan?
If you leave a job that offers a defined-contribution plan, the process is slightly different than with a defined-benefit plan. In a DC plan, your retirement income is based on the amount you and your employer contributed, along with the performance of the investments within the plan.
When you leave the job, you’ll typically have the option to transfer the balance of your defined-contribution plan into a LIRA, RRSP, or another retirement savings vehicle. You’ll continue to have control over how these funds are invested, but the responsibility for generating retirement income rests on you.
Unlike a defined-benefit pension, a DC plan doesn’t guarantee a specific monthly income for life. You’ll need to carefully manage your investments and withdrawals to ensure your money lasts throughout your retirement.
How to Use a Locked-In Retirement Account (LIRA) to Maximize Your Pension Value
A locked-in retirement account (LIRA) is one of the best ways to maximize the value of your pension after leaving a job. By transferring the commuted value of your pension into a LIRA, you ensure that the money remains tax-deferred and locked in for retirement purposes.
To get the most out of your LIRA, consider these strategies:
- Diversify your investments: Within a LIRA, you have a wide range of investment options, from stocks and bonds to mutual funds and GICs. By diversifying your investments, you can spread out risk and increase the potential for growth.
- Manage withdrawals carefully: Once you convert the LIRA into a life income fund (LIF) or registered retirement income fund (RRIF), you’ll need to manage withdrawals carefully to avoid depleting the account too quickly. Work with a financial advisor to create a withdrawal strategy that balances your income needs with long-term growth.
A well-managed LIRA can help you maximize the value of your pension while maintaining control over your retirement savings.
Should You Take the Lump Sum Payment?
For some people, the idea of taking the lump sum payment—whether through a commuted value or a payout from a defined-contribution plan—is appealing. Having the full value of your pension in your hands gives you flexibility and control.
But before you decide, consider these questions:
- Do you have a solid investment plan? Taking the lump sum means you’re responsible for managing the money and ensuring it lasts throughout your retirement. If you’re not confident in your investment skills, it might be better to stick with the pension or annuity option.
- Are you prepared for the tax hit? As mentioned earlier, any amount of the commuted value that exceeds the maximum transfer value will be taxed. Depending on the size of your pension, this could lead to a large tax bill in the year you take the payout.
- Do you have other sources of income? If you have other retirement savings, such as an RRSP, TFSA, or rental property, taking the lump sum might make more sense. You’ll have more flexibility to manage your total retirement income.
Final Thoughts on Maximizing the Value of Your Pension
When you leave your job, the decisions you make about your pension can have long-term consequences for your retirement income. Whether you choose to commute your pension, transfer it to a locked-in retirement account, or purchase a copycat annuity, it’s important to understand the risks and benefits of each option.
By carefully considering your financial goals, risk tolerance, and tax situation, you can make an informed decision that maximizes the value of your pension and secures your retirement future.
