Should you convert your pension into a LIRA?

Hey there, time traveller!
This article was published 22/11/2023 (874 days ago), so information in it may no longer be current.

Dear Money Lady,

My investment adviser wants me to convert my pension into a LIRA/LIF and don’t know if that’s a good idea. Will I have to pay a lot of tax if I do it? I know it will give me a bigger investment portfolio and my adviser would love that but, really, why should I do it?

Thanks,

Brian

Great question, Brian. I am so glad you asked. The first question I would ask you back is: are you on your own, married and/or do you have dependents? Your answer will help make your decision.

When leaving an an employer, a lot of people are not sure if they should leave their pension or move it to a locked-in retirement account (LIRA). The reason for moving to a LIRA would be so you could have full access to your pension amount to invest as you choose. A defined contribution pension is relatively easy to transfer, however a defined benefit plan is different. When you want to convert a defined benefit pension plan there will often be a commuted value that is not transferable and can only be taken out as a taxable lump sum amount. Now, if you have RRSP room, you could reduce the tax burden by moving all or part of the lump sum into your RRSP, but if this lump sum amount is too much you will have to pay taxes on it as income in the year you do your conversion.

I want to work out an example for you so that you can make an educated decision when deciding to convert your pension. Let’s say you are 50 years old, and you have a commuted pension value of $350,000 and your annual pension benefit at age 65 will be $27,000. Now because this is a defined benefit pension plan you would only be allowed to transfer $253,000 to a LIRA. (That number is based on a transfer factor assigned to your age and multiplied by the annual benefit amount.) So, now that we know you can only transfer $253,000 to the LIRA, that leaves $96,000 that will be paid out and taxed. If you don’t have room in your RRSP, you would most likely get about $53,000 after taxes, based on a 45 per cent tax rate.

OK – let’s go a little deeper with this situation and work out whether it was worth cashing out.

You’ve got $253,000 in your LIRA. If you still wanted to get the pension benefit of $27,000 per year at 65 from this smaller amount, you’re going to need to ensure a 5.132 per cent compound rate of return on the investment until the age of 65. Which, I have to say, is probably quite doable. Now, if you add in the $53,000 that you cashed out of your investment portfolio (and you didn’t spend it), your rate of return would only need to be approximately 3.761 per cent compounded annually, which is very doable. That would give you approximately $530,000 as a total investment by age 65 and would allow you to take out an indexed pension amount of $27,000 annually.

In my example scenarios it makes sense to do the conversion and I would recommend it if you were without dependents or a spouse. The other reason you may want to consider it is if you question the long-term stability of your employer. If you have any doubts that your employer might not be able to sustain its pensions, then that would be another reason to cash out. But before you do so, there is one more thing to consider — your benefits. You want to find out if health and dental benefits are voided once you do the conversion. Companies will often only include benefits in your retirement if you are collecting a company pension. So, if you take the commuted value of your pension, just make sure you ask if this changes your benefit eligibility. If it does, makes sure you are OK with it.

There are a number of reasons to stay in your pension plan or to cash out and take the commuted value. A decision like this should really be discussed with your financial adviser to mathematically determine if it’s worth it. You will also want to discuss tax options with your adviser – can you take advantage of income splitting or are there limitations based on the plan being provincially or federally regulated? If this is the case, you may only be able to do a partial unlocking. You want to find out all the options and then make the decision that is right for you.