How will a pension buyback impact your income tax return?

Q. I plan to do a pension buyback for my service with the Government of Canada. Can I deduct the lump sum payment from my total income if I fully pay the amount at once? And will the total income reported on my T4 be reduced if I choose to deduct a certain amount from each pay stub? Looking forward to your reply. Thank you. — Alice A. You’re asking about how your pension buyback will impact your yearly income tax return. Great questions! First, some background: As a participant in the federal government’s defined-benefit pension plan, public sector employees accumulate years of “pensionable service,” which build credits toward an eventual retirement pension. Then, at retirement, your total pensionable service is used to calculate your pension benefits. This total can include current service (all of the full and partial years you’ve worked while enrolled in the pension plan you’re retiring from), service that you’ve transferred from one plan to another (if you switched jobs and were able to take your pension with you to your new job), and service you have “bought back” to cover a period when you were not contributing to the pension (such as during maternity or parental leave, for example). In the federal government’s defined-benefit pension plan, a pension buyback is a legally-binding agreement “to purchase a period of prior service to increase your pensionable service under the federal public service pension plan.” More credited service means a higher pension and it may also mean retiring earlier. Now, on to your questions about how the pension buyback will affect your income taxes. To purchase past service in your pension plan, you can use either registered or non-registered funds. If you use non-registered funds, you can deduct the amount of the buyback on Line 207 (Registered Pension Plan deduction) of your annual tax return. Your buyback payments can only be deducted in the tax year in which they were made—you can’t carry forwarded non-deducted amounts to a following year. Your ability to deduct the full cost of your buyback will depend on the size of the buyback amount relative to your taxable income in the year you purchase the credit. If the buyback amount is larger than your taxable income, for example, you won’t be able to deduct the full cost of the buyback. Some employers will allow you to buy back the pension over a period of time, rather than with one lump sum. This can be a good option if the service buyback amount is greater than your taxable income because you can then spread both the cost and the deductions over a number of years. Even if you can deduct the cost in one year, it’s usually better, from a tax standpoint, to take the deductions over several years, if you have that option. That’s because your tax rate goes up as your income goes up—and it’s usually better to get a smaller deduction at a higher tax rate, than a larger deduction at a lower average tax rate. Another option is to pay for some or all of your buyback with a transfer from your Registered Retirement Savings Plan (RRSP). If you choose this option, you won’t get a tax deduction for the past service you purchase with transferred RRSP funds. In your case, Alice, what’s the right choice? Your task in figuring out the best path forward includes resolving three issues:

the availability of funds to use for the buyback (do you have enough to buy back the past service in one lump sum, or would you need to buy it back little by little, over time?);
the source of the funds you’d use for the buyback (registered or non-registered?); and
the size of the buyback amount relative to your taxable income (is the total cost of the buyback, if purchased in a lump sum, equal to or greater than your taxable income in the year you’d buy it back?)—would it save you more taxes to take the deduction little by little, rather than all at once?

As with so many retirement income issues, you need to balance several factors, including time, funding sources and tax. Once you have the answers to these three questions, however, making your choice should be more straightforward—whether you make the selection yourself, or seek out a second opinion from a professional financial planner. Alexandra Macqueen is a Certified Financial Planner and retirement expert providing advice through Pension Acuity Partners.

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Comments Cancel reply

richard fehr says:

March 16, 2020 at 2:23 pm

Would taking a lump sum out of a Registered Savings Plan have the same implications as taking it from a LIRA or RRSP?

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Nicolas Boucher says:

June 28, 2020 at 11:14 am

Will doing a pension buyback affect my RRSP contribution room?

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Alex Montpetit says:

January 3, 2021 at 11:06 am

Nicolas, I think that it depends if you buy back your pension with already registered money, it will not affect your contribution room because it already used it in the past. If you buy it back with non registered money, it will take up contribution room.

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Charles Crupnik says:

January 18, 2021 at 5:14 pm

Great article on a complex topic. In your comment on Jan 3, 2021, does a buyback with non registered money take up future contribution room or do you need to have the room available before doing the buyback?

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1. MoneySense Editors says:
  
  January 20, 2021 at 10:26 am
  
  Due to the large volume of comments we receive, we regret that we are unable to respond directly to each one. We invite you to email your question to [email protected], where it will be considered for a future response by one of our expert columnists. For personal advice, we suggest consulting with your financial institution or a qualified advisor.
  
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Ed Lannon says:

March 14, 2021 at 7:12 pm

The total buyback was for $12000 which I paid in Dec/19 and my receipt was dated Dec 27/19. I did not have a t4 for the year 2019 and I did not try to claim the buyback. Which year do I make the buyback claim in and if my rrsp room is only $3000 for 2019 how does this affect what I paid.

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1. MoneySense Editors says:
  
  April 6, 2021 at 8:48 am
  
  Due to the large volume of comments we receive, we regret that we are unable to respond directly to each one. We invite you to email your question to [email protected], where it will be considered for a future response by one of our expert columnists. For personal advice, we suggest consulting with your financial institution or a qualified advisor.
  
  Reply
Sally says:

September 20, 2021 at 6:46 am

I think the response to Alice was horrible. You write “would it save you more taxes to take the deduction little by little, rather than all at once?”

How are we supposed to know this? Were not CRA. We don’t know how to calculate our taxes. We don’t have a gross to net salary calculator. They online tool provided by CRA is grossly inaccurate for Government Employees. The Government of Canada pay or pension office refuse to provide any guidance or assistance in this regard.

In fact, a Federal Government employee wouldn’t be able to calculate the Pension Adjustment and Federal Tax deducted from each cheque. Although they can calculate cpp, ei, and superannuation. The federal tax amount always remains a mystery.

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