Why I Will No Longer Contribute To My RRSP

I am one of the privileged few benefitting from an employer-sponsored pension plan. It is becoming increasingly rare these days. Generally, when we tell people we have a pension plan, we’re told how lucky we are.

In addition, there are different types of pension plans. One of them is the mother all of pension plans. I’m talking, of course, about the defined benefit (DB) pension plan. That’s the one offered by my current employer.

For many, it’s an excellent advantage. In my case, it’ll bring me closer to my goal much more quickly. On top of my contributions, my employer’s contributions will be returned to me in part when I resign, through the transfer of the commuted value.

For others, who are not aiming for FI and are not saving anything by themselves, it’s more of a gilded cage than anything else. At least, that’s how I saw it back in the days when I wasn’t saving. But that’s a whole other discussion!

How It Relates to the RRSP

First, the maximum RRSP contribution is the lesser of $27,230 (for 2020) or 18% of the previous year’s earned income.

However, a person with a DB pension plan will not be able to contribute up to 18% of their salary to an RRSP of their own. That wouldn’t be fair to those who don’t have a pension plan.

So, to balance it out, employers must calculate the pension adjustment (PA). This factor must then be deducted from the RRSP contributions.

For those interested (or for nerds like me), the calculation of a PA for a DB pension plan goes as follows:

(9 x annual accrued benefit) – $600

The annual accrued benefit varies from one pension plan to another. It is established as follows:

Pension formula * Annual salary

To give you an idea, I used my December 31, 2019, statement numbers. For your information, the Maximum Pensionable Earnings (MPE) for 2019 was $57,400. My annual accrued benefit is calculated like this:

[(1.5% up to MPE) + (2% above MPE)] * $61,442 = $942

Thus, my PA was calculated as follows:

(9 x $942) – 600 = $7,877

So while my RRSP contributions for 2020 should have been $11,382 (18% of my 2019 salary), my PA brought it down to only $3,505 ($11,382 – $7,877). Then, I could only contribute $3,505 to my own RRSP.

Long story short, the PA significantly reduces a person’s RRSP contribution room for the following year.

Why Stop Contributing?

Let’s keep in mind that I’ll reach FI once I have accumulated 25 times my annual expenses. In fact, I intend to reach this magic number once I take my pension’s commuted value. This amount can be transferred to a Locked-In Retirement Account (LIRA) up to the maximum transfer value (MTV) allowed by the Income Tax Act.

The MTV is calculated like this:

Annual pension at age 65 * Present value factor

The present value factor is based on age.

As an example, here are the important numbers from my December 31, 2019, statement :

• Pension value: $14,100
• Annual pension at age 65: $1,370

By applying the above-mentioned formula, I understand the MTV would have been $12,330 ($1,370 * 9). However, the pension value was $14,100. Therefore, if I had decided to resign on December 31, 2019, there would have been an MTV of $12,330 and an excess of $1,770 ($14,100 – $12,330).

What could I have done with that excess? Either cash it in and pay taxes on it, or transfer it to an RRSP.

However, transferring the excess to an RRSP can only be done when you have enough unused contributions.

Therein Lies the Problem

In order to reach FI, I will take the commuted value when I resign, at the latest, in 2026.

Being the nerd that I am, I have made various projections to estimate the value of my DB pension plan in 2026, as well as what the excess could be. Based on various hypothetical returns and projected salary raises between now and 2026, I estimate my excess could be somewhere between $26,000 and $44,000.

So, if I have no unused contributions left when I take the commuted value, I will have to cash in the entire amount and pay taxes accordingly. With no other income, this means between $4,500 and $10,600 in taxes for someone living in Quebec (according to this calculator).

Even worse: if I earned, let’s say, $60,000 that year before resigning, the excess will be added to my employment income. Worst-case scenario: I would have $104,000 of taxable income at the end of the year. That means I reach a higher tax bracket!

We want to avoid that, don’t we?

So, contrary to what I said in a previous article about maximizing all registered accounts as soon as possible, I must hold off on contributing to my RRSP until I resign. I have to save any unused contributions for later.

Also, let’s not forget that the PA significantly reduces my RRSP contributions each year.

Considering this, and the fact that my RRSP is currently maximized as of 2020, I estimate I’ll barely have $20,000 in unused contributions in 2026. Thus, there’s still a risk of not having enough unused contributions to absorb the entire excess.

To make up for this, I could resign at the end of the year and receive the excess at the beginning of the following year. In that next year, I would have no employment income. I would also have new RRSP contributions to add to the previous years. Finally, what wouldn’t fit in the RRSP could be used as income for my first year of early retirement. I would probably only make a partial withdrawal (less than 4%!) of my investments to make up the difference in that first year.

With a little luck, the amount would still be less than the basic personal amount and then, I wouldn’t have any taxes to pay. 🙂

Other Options

So if I can’t touch my RRSP until 2026, what do I do in the meantime?

I use the very wonderful TFSA until it’s maximized, of course. As of today, I still have about $45,000 left in unused contributions. We can assume an increase of about $6,000 in contributions a year. Maybe more, if we’re lucky!

If I keep saving $25,000 a year on average, I should be able to catch up on my TFSA contributions by early 2023.

Once that happens, I’ll need to start investing in a non-registered account. This type of account has no limit, unlike registered accounts. At that point, I would contribute the $6,000 (or more) per year to the TFSA and all the rest of my savings would go in a non-registered account.

Deferred Pension or Commuted Value Transfer

Some may wonder if it would not be better to just take the deferred pension and not bother with all the calculations I have just explained.

It depends.

If you’ve been contributing to your pension plan for a long time, then the commuted value, as well as the excess, could be really significant. For example, if you have $100,000 in excess and no unused RRSP contribution, the tax bill would be huge!

In this article, the author explains in detail his strategy. In his case, the commuted value was $290,143. He was surprised to learn that the MTV he could put in a LIRA was only $134,028. That means he had an excess of $156,115. More than half of his commuted value would be taxable, at a rather high marginal tax rate! In any situation, there is little chance that unused RRSP contributions could absorb all of this.

A person living in Quebec would have to pay $59,798 in taxes on such an amount. That reduces the real commuted value by a lot, doesn’t it? In the end, out of his $290,143 commuted value, he would really only get $230,345. That can make a big difference in terms of FIRE. Personally, I wouldn’t be willing to sacrifice close to $60,000!

You understand that it is therefore very wise to do your calculations before making any decision.

Furthermore, are you a good enough investor to “beat” the deferred pension provided by the plan, if you invest the commuted value yourself? And how many years do you have left before you can take the deferred pension?

These are many factors to consider. For my part, I much prefer to proceed as I have detailed, because that is what will allow me to reach my number much earlier. I made a plan to optimize everything and make sure I pay as little tax as possible. But for someone else, the reality could be completely different.

My Own Personal Experience

When I left my former employer in 2018, I was promised an annual pension of $3,314 at age 65. Nothing to write home about, right?

The other option was to transfer the commuted value of $42,000, of which $12,000 was in excess. Fortunately, I had plenty unused contributions at the time to absorb it all. So, the decision was easy to make. 🙂

Two years later, I am more than happy to have taken the commuted value to a LIRA and the excess to my RRSP. It has given a huge boost to my personal investments. It makes even more sense now that I am aiming for FI.

In fact, I’ve had an excellent return on my commuted value by investing it myself so far. Thanks to Passiv, I can give you an overview of my LIRA return since I opened the account two years ago.

So, the boring answer to the initial question is: it depends. It’s up to you to do your calculations.

The Importance of Planning

If I’d never bothered doing calculations, I’d have continued to maximize my RRSP every year until I resign.  The result could have been a tax bill up to $10,000. It would be even worse if I were to receive the excess the same year I resign, as it would be added to any income already earned. I would then reach a higher tax bracket and the tax bill would be even higher!

That’d mean less money in my pockets, more in the pockets of the taxman. By planning everything in advance, I make sure that I maximize the money I will keep from my commuted value.

It’s always ideal to get as close as possible to 100% of our money. In other words: pay as little tax as possible. This applies just as much to the 4% rule, which indicates to have 25 times your annual expenses. To be realistic, this amount must be net of any taxes. If you haven’t planned for (or optimized) this important aspect and you end up sending a third or your passive income to the taxman, you’re going to run out of money. So you have two options:

• plan for a larger amount to cover taxes; or
• optimize your taxes.

I know which one I prefer. As Pierre-Yves McSween puts it:

As much as we hate taxes when we build our wealth, we can benefit from tax rules once we have enough.

When you know how things works, you can make the most of it.

For the Lucky Few

This article was certainly aimed at a somewhat smaller audience, namely people benefiting from a DB pension plan. Even for them, it may not have been the most exciting article! There were a lot of calculations, formulas and complex terminology. On top of that, the terminology seems to differ from one pension plan to another! I hope I managed to be coherent, under the circumstances.

However, it did allow me to put together all the information I gathered on the subject and it helped me refine my strategy. I hope my thoughts on the subject helped some of you.

Have you ever had a DB pension? Have you ever had to choose between a deferred pension and a commuted value transfer? What did you choose? Or are you currently one of the lucky few? If so, what’s your game plan for when you leave the rat race?

Feel free to leave a comment! Seriously, I want to know. I’m that much of a nerd.

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