Retirement for the Self-Employed: A Guide to Canadian Pension Sources
For many of us, retirement seems like a long way off and consequently we perhaps don’t spend enough time thinking about it until it’s too late to make much of a meaningful change. Unlike employees, business owners don’t receive consistent cash flow in the form of a salary nor do they have the safety net of an employer-sponsored pension plan. Excess profits are often reinvested in the business or simply accumulate in a bank account while you attend to more pressing matters. This is why having a some sort of retirement plan is essential.
The Power of Compounding
To demonstrate the power of compounding, consider this: 5,000 per year over 30 years i.e. a total investment of $150,000 invested at 5% (which is lower than the average return on the stock market) would result in $338,899.11 at the end of 30 years. This applies to all types of investments and is essentially the power of compounding which is a function of the rate of return and time i.e. the number of years the investment is earning the return. This demonstrates that contributing, even small amounts, as early as is possible, can lead to a significant nest egg.
Sources of Retirement Income for the Self Employed
Unlike employees, business owners don’t receive consistent cash flow in the form of a salary nor do they have the safety net of an employer-sponsored pension plan. Excess profits are often reinvested in the business or simply accumulate in a bank account while you attend to more pressing matters. This is why having a some sort of retirement plan is essential.
The key sources of retirement income available to Canadian small business owners
(There is also Old Age Security, but this is automatic at retirement)
Canada (Quebec) Pension Plan(CPP or QPP)
The CPP is a government-administered program that essentially provides a basic level of retirement income. Contributions are mandatory.
If you are an employee or owner manager of a corporation that receives a paycheque, you will contribute roughly 6% of your gross pay (up to a maximum salary amount of approximately $80k) while your employer/corporation contributes an equal amount.
If you are self employed, since you don't have an employer, you must contribute twice the amount of an employee or about 12% . The maximum salary amount is the same.
While this may seem like a significant amount, the advantage of mandatory contributions is that you are guaranteed to receive a pension upon retirement.
Currently, the maximum CPP benefit is projected to be $1,500 per month, but most Canadians receive less, with the average around $800 per month. Note that this is indexed to inflation and will increase each year.
The amount that you receive depends on how much you have paid into the plan which is directly proportional to your earnings and how many years you have contributed.
Registered Retirement Savings Plans (RRSPs)
While CPP provides a foundation, it’s often not enough for a comfortable retirement. Consequently, if you do not have another type of pension plan or a nest egg, it is important to have RRSPs.
An RRSP, for those of you who don't know, is a tax-deferred savings account that allows you to set aside money for retirement. The benefit and incentive of RRSPs is that contributions, up to a maximum limit, reduce your taxes payable in the year that you contribute.
To contribute, you would set up an RRSP account with your bank or a brokerage and invest your contributions. These investments will then grow over time.
As an incentive to start as soon as possible (although it is important to remember that it is never too late) consider the example above where we looked at the power of compounding.
The maximum amount you can contribute in any given year is the total of:
18% of the previous year's earned income (this can be found on your notice of assessment for last year)
Plus
Any unused contribution room from previous years (also on your notice of assessment)
Since RRSPs reduce your taxable income, the benefit is greater when you have higher levels of income that are subject to a higher tax rate.
While you can withdraw from most RRSPs anytime, you will have to pay tax (at your current tax rates) if done before retirement and you lose the contribution room. So, while early withdrawal is an option, it is not recommended.
Once you do retire, you would convert your RRSP to a RRIF and are required to withdraw a minimum amount each year starting at age 71. The amount that you take out is then taxable.
Other Sources of Retirement Income for the Self Employed/Small Business Owner
Old Age Security (OAS)which is a monthly stipend paid to all Canadians at approximately the same rate. Currently this is about $740 per month. Note that above a certain amount of income, this is clawed back.
Tax Free Registered Savings (TFSA) Withdrawals are 100% tax-free at any time and don't count toward the OAS clawback
Employer Pension Plan (RPP) is usually applicable to employees who work for the government as well as some businesses in the private sector.
Corporate Investment Portfolios for those who are owners of corporations and have set up investment portfolios for their excess earnings
Other Personal Assets/Savings including home equity, especially if you expect to move after retirement and non registered savings/investment account.
How Much Do You Actually Need?
No matter what stage of life you are in, it is useful exercise to estimate how much you might need to retire. There are a variety of retirement calculators out there. This one from Revenue Canada is quite thorough. I also like this one from Wealthsimple. Note that like with all estimates, it doesn’t have to be exact. But most of us can extrapolate our future expenses based on our current lifestyles.
Steps to Start Saving
Like with anything difficult, it is helpful to build a habit around saving.
Once you know how much you want, you can work backwards (using an online calculator and some assumptions) to determine how much you need to save monthly or annually.
Create an entry in your calendar to remind yourself to contribute or automate withdrawal of a monthly amount from your bank account.
Make sure your underlying investments are consistent with your long term goals by speaking with an advisor at your bank/brokerage or a financial planner.
If you feel stressed about whether you’re saving enough for retirement, you’re not alone—this is a common sentiment among many Canadians. The good news is that it isn't that hard to assess your situation and make small, consistent efforts towards building a comfortable retirement.
