Today we’ll be going over what happens when choosing the lump sum payout option from your defined benefit pension plan.
As you’re likely aware, a defined benefit pension plan will pay you a monthly income for life, so why choose the lump sum payout option instead? A few common reasons include:
Pension sustainability: Will your company and its pension be around long term?
Income Flexibility: You get to decide how much you get paid every month
And lastly, asset control: The money remaining from the payout can be passed on to your kids or favorite charity upon your death rather than it staying within the pension plan.
Once the lump sum payout option is chosen, there are generally two payments that occur. For example, let’ say you retired with a million dollar pension, your actual payout may be divided as $600,000 to a locked-in account with the remaining $400,000 coming to you as a cash payment. The Income Tax Act will determine how your payout is divided, but we won’t get into those calculations today
So what is a locked-in account?
If your pension plan is based out of Manitoba, the $600,000 which must remain locked-in would be deposited into an account called a LIRA or a Locked-in Retirement Account. The benefit of this account is that there would be no immediate tax consequences upon the transfer of the funds. This means the $600,000 could move from your pension to the LIRA and you wouldn’t have to pay any income tax. The funds could also be left to grow inside the LIRA tax-deferred until you reached the age of 71
Once you’re retired and need access to the funds in the LIRA, you would need to convert it to a LIF or Life Income Fund. The reason for this is that you aren’t able to make withdrawals from a LIRA, but you can from a LIF. However, there are restrictions on the LIF which limit the amount of money you can withdraw from the account.
These limits are based on your age. For example, if you had $600,000 in a LIF at age 65, you’d be obligated to withdraw at least a minimum of 4% from the account ($24,000) over the year, and the maximum you could withdraw would be 7.2% ($43,200). The percentages you’re allowed to withdraw will increase every year as you age. For example, at age 70, the minimum percentage would be 5, and the maximum would be 7.9%.
What if you want more today?
If you wanted to withdraw more money from your LIF due to cash flow reasons or tax planning, you would have the option of exercising a one-time unlocking of 50% of the value of your LIF. This is done through a PRIF or Prescribed Retirement Income Fund. Up to 50% of the LIF could be transferred to a PRIF and the advantage of this account is that there are no restrictions on the maximum amount you can withdraw every year. So Rather than having $600,000 in a LIF, you could instead $300,000 in a LIF and $300,000 in a PRIF. This would allow you to withdraw more from your locked-in accounts
So, those are your options on the locked-in portion of the pension payment, but we still have a $400,000 cash payment that we need to deal with.
The $400,000 would be considered taxable income, and because it is taxable, you would receive a cheque for $280,000 as your pension would withhold 30% for taxes. Based on 2018 Manitoba and Federal tax rates, you would be left with a tax bill of roughly $55,000. If you paid this with the remaining cash from your payout which we’ll call option 1, you’d be left with $225,000.
If you have RRSP room available, you can be a lot more tax efficient with your payout. For option 2, let’s say you had $250,000 worth of RRSP room available and you used it all in the year you retired, not only would you wipe away the $55,000 tax bill but you would also generate a refund of approximately $70,000. That would leave you with $250,000 in RRSPs as well as $100,000 in cash for a total of $350,000. That’s $125,000 more in your pocket compared to Option 1
As we’ve covered, the lump sum payout isn’t as simple as receiving a large cheque. There are many factors to consider and many outside the pension that we haven’t covered today, such as possibly receiving a severance package and vacation pay.
For help with your personal situation, feel free to reach out in the Contact Us section, and we’d be happy to help.
Marc Sabourin is a Winnipeg based Financial Advisor with Harbourfront Wealth Management. His focus is on helping pensioned employees achieve their retirement goals. He draws on his real-life experiences to explain strategies that are often presented as intricate. He believes financial literacy is an integral part of one’s financial well-being and his goal is to make learning about these topics fun and enjoyable.