Saving enough money to build a decent retirement corpus is a big challenge for almost all citizens of Canada. When one is engaged in paying off mortgages, credit card bills and saving money for emergency situations, saving to build a retirement fund usually gets ignored. Before they were discontinued in 2017, Canada Savings Bonds were a great option. For scenarios like that, employer-sponsored retirement plans come to the rescue. These funds have the power to fill in the gaps between your own funds and the amount that is needed for building a solid retirement corpus. If you start a new job and your company offers a Deferred Profit Sharing Plan (DPSP), you might be wondering how to take advantage of that. This post will help you learn all you need to know about Deferred Profit Sharing Plans (DPSP).
What Is a Deferred Profit Sharing Plan (DPSP)?
A Deferred Profit Sharing Plan (DPSP) may be a combination of a pension and retirement plan sponsored by employers to assist workers with their retirement. A DPSP is made when a corporation distributes a part of their profit among their employees’ DPSP account. Only employers possess the ability to make contributions to a DPSP. Employees don’t have to pay taxes on contributions until they withdraw money from their DPSP.
Companies create DPSPs to entice prospective employees (and to encourage current employees to stay) and to reduce their tax burden. The reason behind that is the fact that all of the company’s contributions are tax-deductible.
How Does a DPSP Work?
It’s not like getting a personal injury lawyer. The workings of a DPSP are as such. The company goes over their accounting for the year and reports a profit on a regular or irregular basis.
They plan to share a part of the profit with their employees within the sort of distributions that make up their Deferred share Plans. The money they distribute is tax-deductible for them and tax-deferred for the workers. Companies have 120 days after the end of the fiscal year to make their contributions.
The employees then receive these proceeds, and they can use it to invest in various funds, stocks, or bonds. They can also buy company stock with the money. Employees don’t have to pay taxes on these contributions unless they withdraw and claim the income on their taxes. When the employee signs up for a DPSP, they’ll designate someone as their beneficiary. That beneficiary is usually a long-term partner or spouse.
DPSP vs. Profit Sharing Plan
A DPSP and a share plan both operate on equivalent fundamentals. When a company has profit, it can share that profit with its employees as a major benefit. When there’s no profit, the company doesn’t have to make any contribution. A company can set its own limits on how much profit it needs to have before distributing it to the workers.
The most important difference between a DPSP and a general share plan is that employees need to record share contributions on their taxes unless they need a DPSP. If a corporation distributes profits without a DPSP, then the cash is taxable.
This makes a DPSP much more favourable when compared to a normal profit sharing plan. If your company doesn’t use a DPSP to distribute profits, ask the person in charge to see if he/she can create a DPSP system.
DPSP vs. RRSP (Registered Retirement Saving Plan)
In certain cases where an employee possesses both a DPSP and an RRSP, the DPSP contributions will be deducted from the employee’s RRSP limit. If the person’s company adds $1,000 to their DPSP, that’s $1,000 less they can contribute to their RRSP.
If the company adds $1,000 to the employee’s account and they quit the next day, that money is theirs.
Differences between a DPSP and RRSP
Employer contributions to an RRSP are automatically vested so an employee can leave and take the RRSP with them. A DPSP may have a vesting period of up to two years. This can be a sticking point, but since a DPSP is essentially free money from the company, it doesn’t matter as much unless you receive a much better job offer elsewhere.
DPSPs and RRSPs have different contribution limits. In 2019, the annual maximum for a DPSP was $13,615. The 2019 limit for an RRSP was 18% of your income or $26,500, whichever was lower. Employees should also be aware that their DPSP contributions will affect how much they can contribute to their RRSP.
What are the Advantages of DPSP?
Employers hold the right to make contributions only when they want to. If a company has a bad year, they don’t have to put any money into a DPSP. Employers are free to make their own contribution schedule. The schedule can be both on a monthly or sporadic basis. They can put DPSP contributions into each pay period or reserve it for their annual bonuses. A DPSP can have a maximum vesting period of two years, which can prevent turnover within a company. An employee who leaves before the vesting period has no choice but to forfeit the DPSP.
A company can decide which formula to use when distributing money into a DPSP. They can pick a basic formula, like “everyone receives an equal share of the profits” or “employees receive a percentage of their salary up to a certain amount.”
Contributions are tax-deductible for the employer, which is considered preferable to a regular profit sharing plan.
Advantages for the Employee
The biggest advantage of a DPSP is that it’s entirely funded by employer contributions. The employee doesn’t have to put any money into a DPSP to receive the full employer contribution. This makes it free money for the employee.
A DPSP has a maximum vesting period of two years. Employees only have to stay at a company for two years to receive full access to their DPSP. This is a relatively short vesting period. Your company may have an even shorter vesting period or make employees automatically 100% vested. Speak to your company’s incharge of finances to find out about the DPSP vesting period.
You have immediate access to the DPSP funds once you’re vested. Funds in a DPSP may be withdrawn before retirement, but they’ll be taxed at the employee’s current tax rate. If the tax rate is 26%, the employee will pay 26% taxes on those DPSP withdrawals. That’s why experts suggest not touching the money until you’re retired because you’ll likely be in a lower tax bracket.
What are the disadvantages of DPSP?
Disadvantages for the Employer
Because a DPSP is an employee-only plan, owners, their relatives and spouses and anyone with more than a 10% stake in the company is prohibited from having a DPSP. This can be a drawback for the senior executives, especially if there’s a lot of extra profit. This can also affect how companies reward their top leaders with extra incentives.
Distribution of DPSPs depends on the employer having profits. Consequently, if the company has a bad year financially, the employer may not make any contributions. This can be disappointing to employees and affect the firm’s turnover. When deciding on a DPSP, companies should consider the likelihood of having enough profit per annum to contribute to a DPSP.
Disadvantages for the Employee
A possible disadvantage for the employee is that the employer can require the employee to purchase company stock with his/her DPSP funds. This isn’t true for all DPSPs, but can be a possibility. Employees who don’t have full control of their DPSP investments should make sure they’re diversified in their RRSP or other retirement accounts.
If the employee purchases company stock and the value drops significantly, their DPSP could be rendered worthless. This is why a DPSP that has little control for the employee isn’t as valuable as a DPSP without excess oversight.
If an employer has a low profit margin or didn’t generate enough revenue, a contribution to a DPSP is not compulsory. This can make retirement planning more volatile for employees who are solely relying on their DPSP. If the DPSP is your main source of investing income, consider what you’ll do if your company can’t afford contributions in a given year.
The DPSP is an employee-only plan, so you can’t split the funds with your spouse. This is a major difference between a DPSP and an RRSP.
How to Transfer a DPSP to an RRSP
When an employee leaves a company, they can take their DPSP with them to transfer to an annuity, Registered Retirement Income Fund (RRIF), or an RRSP. Employees can also cash the amount out. If they receive the amount as a check or cash, they have to report it on their taxes and pay income tax on it.
If you have a significant amount of money in your DPSP, you can do a direct transfer to an RRSP to avoid taxes. Contact the DPSP provider to ask how to transfer the money into your RRSP account. If you don’t have an RRSP account yet, set one up beforehand. It’s crucial to do a direct rollover from your DPSP to your RRSP in order to avoid a huge tax burden. In order to transfer your DPSP to an RRSP, you must be 71 years old or younger.
In case of the death of your spouse or partner and reception of his or her DPSP, you have the option to transfer it to your RRSP account. If you and your spouse have a divorce and the divorce agreement provides some or total ownership of your former spouse’s DPSP to you, you have the option of transferring that to your RRSP as well.
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