If you’re a former teacher or public sector worker now charting your own path as a business owner or investor, the idea of commuting your pension might be sitting in the back of your mind. It’s a decision that can seem confusing, risky, or even reckless to some — but for others, it might be the most strategic move on the board.
In this article, we’ll break down what it means to commute your pension, why interest rates and timing matter, what happens to your funds, and how you can avoid paying more tax than necessary. Along the way, we’ll follow the journey of “Ben,” a former Ontario teacher, now incorporated business owner, who’s weighing this very decision.
What Does It Mean to Commute a Pension?
When you commute your defined benefit pension (such as the Ontario Teachers’ Pension Plan, or OTPP), you’re essentially choosing to take the present value of your future guaranteed monthly pension payments as a lump sum today.
This lump sum is split into two parts:
- The “locked-in” portion, which must be transferred into a LIRA (Locked-In Retirement Account).
- The “cash” portion, which is paid out to you directly and is taxable as income in the year you receive it.
In most cases, when you commute a defined benefit pension in Canada, the payout is split into these two portions for two main reasons.
For the “locked-in” portion, it is to ensure that you do in-fact keep those tax deferred dollars saved for the intended purpose: a pension.
However, many wonder why they are being forced to take a “cash” portion – especially when they’d rather keep those dollars tax deferred and tax sheltered for retirement use.
Unfortunately there are transfer limits under the Income Tax Act (ITA) that sets annual maximum limits for how much can be tax-sheltered when commuting a pension. These limits are based on age and pension entitlement, and they effectively cap how much can go into a LIRA. Any excess over that limit is non-eligible and must be paid out in cash, taxable immediately.
Example: If your commuted value is $800,000, but only $700,000 qualifies for a tax-deferred transfer into a LIRA, the remaining $100,000 will be paid to you in cash and added to your taxable income for the year.
Strategy Tip
If you’re anticipating a significant cash portion, you can plan ahead by:
- Lowering personal income in the year of commutation (e.g., draw less salary/dividends from your corporation)
- Using available RRSP room (if any) to absorb some of the cash portion
- Exploring advanced strategies (e.g., using insurance or corporate tax planning) to reduce the long-term impact
Why Timing and Interest Rates Matter
Pension commuted values are closely tied to long-term bond yields. When bond rates are low, the present value of your future pension is high — because the plan assumes it will take more money today to fund the future payouts.
When interest rates rise, the opposite happens — the commuted value drops.
Example: In the early months of COVID, bond yields plummeted to record lows. For anyone walking away from their pension around 2020-2021, it was an ideal time to commute — assuming it aligned with their broader financial plan.
Ben’s Dilemma: Is It Worth It?
Ben, a former Ontario teacher and now a successful business owner, recently reached out with this question:
“It sounds like the cash portion of the commuted value will be taxed as a lump sum at approximately 30%. Is there a way to shelter that tax and get some of it back with strategic investments of the remaining amount?”
He’s right to be concerned. If, for example, $97,000 of the commuted value is designated as the cash portion, a 30% withholding tax reduces that to around $68,000.
Typically a 30% withholding tax is applied on the taxable “cash” portion of a commuted pension if it exceeds $15,000, which is the case here for Ben. However, it is important to note that this withheld tax amount is submitted to the CRA on behalf of Ben as a prepayment towards his total tax owing for that calendar year.
Therefore, he isn’t necessarily losing that 30% withholding tax permanently – especially if he is able to keep his personal earned income down in that given year.
If his marginal tax rate is less than 30% in the year he commutes his pension, he should receive a refund once he files his tax return. However, if his marginal tax rate is greater than 30%, then he will actually owe more once he files his income tax for that tax year. Here’s a useful income tax calculator I like to use for the different provinces across Canada.
The Strategic Response: Managing the Tax Hit
Here’s how we explained commuting the Ontario Teacher’s Pension Plan (OTPP) to Ben — and how you can think about commuting your Defined Benefit Pension Plan (DBPP) too:
1. Know the Split: Locked-In vs Cash
Most of your pension commutation will go into a Locked-In Retirement Account (LIRA), and won’t be taxed immediately. The smaller cash portion, however, is taxable in the year you receive it.
Unfortunately, unless you have available RRSP contribution room, you cannot shelter the cash portion by rolling it into a Registered Retirement Savings Plan (RRSP). That means you’ll pay tax based on your marginal income in the year you commute.
2. Control Your Personal Income That Year (If You Can)
If you’re a Canadian incorporated business owner, you have a powerful tool: income flexibility.
Let’s say the taxable cash portion is $65,000. Instead of drawing your usual $80,000 salary from your corporation that year, you could reduce it to $15,000 or less. This helps avoid pushing yourself into a higher tax bracket and softens the blow of the taxable pension funds. You’ll end up paying the same amount in personal income taxes for that income tax year, however you won’t have to take it from your corporation. Bonus!
✅ Smart move: Plan your commutation year in advance (e.g. Jan 2026) and coordinate your corporate income accordingly.
Of course, if you are not incorporated and are now working another salary or hourly T4 job, you unfortunately will not be able to control your income aside from actually working less that year. Sabbatical anyone?
3. Offset Future Tax Through Strategic Investing
The goal isn’t to “get the tax back” in the literal sense — but to outperform what the pension would have given you through well-structured investing.
Here’s a simplified breakdown:
- Ben is 42 years old.
- If he commutes today, he needs to earn ~5–5.5% annually on his commuted funds to match his unreduced OTPP pension payouts starting at 50, 55 or even at 65.
- With disciplined investing in low-cost index funds (e.g. 60% U.S., 25% international, 15% Canadian), many investors have historically earned 7–9% on average over the long term.
That means Ben has a good shot at not just replacing, but exceeding his future OTPP pension payments — especially if he continues to invest additional funds beyond the commuted amount.
Using Whole Life Insurance to Support Your Strategy
Ben already owns a high early cash value participating whole life insurance policy inside his corporation. That serves as a:
- Tax-advantaged, liquid asset that complements his portfolio
- Safety net for emergencies or future borrowing
- Long-term estate and legacy tool
By combining a commuted pension with this type of policy and a well-diversified portfolio, Ben builds a flexible, tax-smart wealth engine that serves him far beyond the traditional pension structure.
As a bonus, since he will be taking out about $60,000 less from his corporation in the year he commutes the pension, those $60,000 will remain as retained earnings in the corporation and can be used to fund his existing high early cash value participating whole life insurance policy.
Should You Commute Your Pension?
If you are a Canadian with a Defined Benefit Pension Plan (DBPP) like Ben is with his Ontario Teacher’s Pension Plan (OTPP), you might be wondering if commuting your pension is the right move.
Unfortunately, there is no one-size-fits-all answer — but if you:
- Have left or plan to leave a defined benefit pension before age 50
- Have strong investing discipline and/or a trusted financial advisor
- Own a corporation and can manage your income year by year
- Want more control, flexibility, and legacy planning options
…then commuting your pension might be the best wealth-building decision you ever make.
But timing is key. And so is planning.
Worth noting – with the Ontario Teacher’s Pension Plan (OTPP) anyway – is that the younger you are when you leave teaching, the more favourable it is to commute the pension and your last opportunity to commute is before age 50. This is because you have more time for compounding to take effect on your commuted value.
Considering Commuting Your Pension?
We’ve helped dozens of clients like Ben — former teachers, government employees, and other pension-holders — build smarter, more agile financial strategies using tools like:
- Corporate and personal investing
- Whole life insurance for liquidity and legacy
- Tax minimization and income control strategies
👉 Take our Financial Health Assessment to see whether you’re on the right track to building the financial future you’ve been after.
👉 Then, book a discovery call to explore whether commuting your pension fits into your overall wealth vision.
Disclaimer: This content is for educational purposes only and does not constitute financial, legal, accounting or investment advice. Always consult with a qualified advisor before making investment, tax, accounting or legal decisions.
