Buybacks Require Careful Planning
Employees who participate in a registered pension plan (RPP) have the option of buying back one or more years of prior service for the years when they did not contribute to their plan. This buyback enables them to increase the amount of their future pension or to retire earlier. However, the resulting tax impacts vary depending on the payment method and the period of past service bought back. Analyzing the impacts of a buyback is complex. It is therefore important to understand the terms and conditions in order to make an informed decision.
The tax treatment of a buyback depends, on the one hand, on the payment method used. You can use amounts from an RRSP or a non-registered account to buy back prior service. On the other hand, the tax impact of the buyback varies depending on whether the years bought back were before 1990 or after 1989. Let’s take a closer look.
Buying back prior service for years after 1989
If an individual wants to buy back a year of service in his RPP, the pension plan administrator calculates a “Past Service Pension Adjustment” (PSPA). This PSPA represents the tax cost of the buyback and reduces the member’s RRSP contribution room.
If an individual has used all his RRSP contribution room, his only option is to buy back his service using the amounts from his RRSP. However, if he has unused contribution room, he has two options:
1. Transferring amounts from an RRSP
In this case, RRSP contribution room is not reduced but tax deductions are not allowed.
2. Using amounts from a non-registered account
In this case, RRSP contribution room is reduced by an amount equal to the PSPA and tax deductions are allowed. The entire amount is deductible, but only in the year the payment is made. Consequently, even an individual who buys back an amount that is higher than his income for the year cannot defer the deduction to a subsequent year. Using non-registered amounts to buy back prior service is nevertheless strongly encouraged.
Buying back prior service for years before 1990
No PSPA is calculated for the buyback of prior service before 1990. Only amounts from non-registered accounts can be used to buy back prior service.
To determine the tax treatment, it is necessary to check whether the individual contributed to an RPP for the year in question. If so, even if it was to an RPP of another employer, the rules for an individual who contributed to an RPP must be applied. The following rules are in effect:
Buying back prior service when no contributions were made to an RPP
In general, a person in this situation can deduct a maximum of $3,500 ($5,500 in Quebec) per year bought back. The deduction will therefore be spread over time. Certain amounts may not be deductible in some rare situations.
Buying back prior service when contributions were made to an RPP
In this situation, an individual can deduct $3,500 per year bought back, but only after having taken into account his current contributions to an RPP and any other buyback costs. Therefore, an individual who is still working and contributing to an RPP may end up paying immediately to buy back prior service before 1990, but deducting it only at retirement.
The buyback of prior service is governed by complex rules that differ depending on the circumstances. We therefore recommend that you meet with your advisor before making a decision. Your advisor can help you choose the best option for your situation.