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.