How to Avoid Tax on Severance Pay in Canada: Strategies and Considerations

Losing a job is stressful enough without having to worry about the tax implications of your severance package. Understanding how severance pay is taxed in Canada and the available options to minimize that tax burden can significantly impact your financial well-being during a period of transition. This is a crucial aspect of financial planning after job termination.

The core question, how to avoid tax on severance pay in Canada, doesn't have a simple yes or no answer. While you can't completely avoid taxes on severance pay, as it's considered taxable income, there are several strategies to minimize the immediate tax impact and potentially reduce your overall tax liability. This article will explore these strategies in detail.

Understanding Severance Pay and Taxation in Canada

Severance pay, also known as termination pay, is compensation an employer provides to an employee who is terminated from their position through no fault of their own. Generally, employees who have worked for the same employer for at least 12 consecutive months are eligible. It is important to note that provincial, territorial and federal regulations, along with individual employment contracts, will dictate the details.

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Crucially, the Canada Revenue Agency (CRA) views severance pay as taxable income. This means a portion of your severance will be withheld for income tax. The specific amount withheld depends on several factors, including how your severance is structured (lump sum, salary continuance, or deferred payments) and your overall income for the year.

Strategies to Minimize Tax on Severance Pay

Transferring to an RRSP: The Primary Strategy

One of the most effective methods to reduce the immediate tax burden on your severance pay is to transfer it directly into a Registered Retirement Savings Plan (RRSP). This is often the most recommended approach for those who are eligible.

Here's how the RRSP transfer works:

• You instruct your employer to transfer all or a portion of your severance pay directly into your RRSP.
• If you qualify, and the transfer is done correctly, your employer will not withhold any income tax at the time of the severance payment. This is a significant advantage.
• You must have sufficient RRSP contribution room available to make this transfer. The amount you can transfer is limited by your available contribution room.
• The funds must typically be transferred within 60 days of receiving the severance payment, or within the same calendar year.
• It's crucial to understand that you're not avoiding taxes entirely; you're deferring them. You will pay income tax on the money when you eventually withdraw it from your RRSP during retirement. However, the assumption is that you'll likely be in a lower tax bracket in retirement, resulting in a lower overall tax burden.
• You may be able to transfer funds to a spousal or common-law RRSP, but contribution limits still apply.

A critical caveat: If you directly transfer your entire severance to an RRSP, you cannot deduct any legal fees incurred in obtaining that severance.

Deferred Payments: Spreading Out the Tax Burden

Another strategy is to negotiate with your employer to defer your severance payments over a longer period, typically one to two years. This approach doesn't eliminate taxes, but it can potentially lower your tax liability in each individual year.

Here's the rationale behind deferred payments:

• By spreading the income across multiple tax years, you may fall into a lower marginal tax bracket in each of those years. This can result in a lower overall tax bill compared to receiving the entire amount in a single lump sum.
• However, not all employers offer deferred payments as an option, so this requires negotiation.
• If interest accrues on the deferred payments, that interest will be taxed as income.

Salary Continuance: Regular Payments, Regular Taxation

Salary continuance involves continuing to receive regular payments from your employer for a specified period after your termination. While this provides a steady income stream, it's taxed similarly to regular employment income.

Key points about salary continuance:

• You'll receive regular paychecks, and income tax will be withheld as usual.
• You'll also be required to pay Canada Pension Plan (CPP) or Quebec Pension Plan (QPP) contributions, as well as Employment Insurance (EI) premiums, on these payments. This differs from a lump-sum severance payment, where CPP/QPP and EI are not withheld.

Retiring Allowance and its Tax Implications

Severance pay can sometimes be classified as a "retiring allowance," which is a payment in recognition of long service upon retirement. It's crucial to distinguish this from regular pension payments.
A retiring allowance can be transferred to an RRSP or Registered Pension Plan (RPP), but specific contribution rules apply. Notably, a retiring allowance earned for years of service before 1996 might not impact your RRSP contribution room.

Understanding Withholding Tax on Retiring Allowances

If you are receiving your severance as a retiring allowance, it is subject to withholding tax, this can change depending on where you live:

It's important to note that your annual tax return will ultimately determine the final tax owed on the retiring allowance, potentially resulting in a refund or additional taxes payable.

Lump-Sum Payments: The Most Straightforward, Highest Taxed Option

Receiving your severance as a single lump-sum payment is the most straightforward approach, but it typically results in the highest immediate tax burden. Your employer will withhold income tax based on your marginal tax bracket. A large severance payment could potentially push you into a higher tax bracket, increasing the percentage of tax withheld.

With a lump sum, there are no CPP/QPP or EI deductions.

The Importance of Professional Advice

Navigating the complexities of severance pay and taxation can be challenging. The best approach depends heavily on your individual circumstances, including your age, financial situation, RRSP contribution room, and the specific terms of your severance package. Therefore, seeking professional advice is highly recommended.

Consider consulting with:

• An accountant or financial advisor: They can help you assess your tax situation, model different scenarios, and determine the most tax-efficient strategy for your severance pay.
• An employment lawyer: They can review your severance package to ensure you're receiving the correct amount and advise you on your legal rights and options. Remember that legal fees related to your severance are tax-deductible, unless you transfer the entire severance amount directly into your RRSP.

Conclusion

While you can't completely eliminate taxes on severance pay in Canada, understanding the available strategies can significantly reduce your tax burden and improve your financial outlook during a job transition. The RRSP transfer is often the most powerful tool for immediate tax reduction, but deferred payments and careful planning with salary continuance can also be beneficial. Remember that the best approach depends on your unique situation. Seeking professional advice from a financial advisor and an employment lawyer is crucial to making informed decisions and maximizing your after-tax severance amount. Don't hesitate to explore these options further and discuss your specific circumstances with qualified professionals. What steps will you take to minimize the tax impact of your severance pay?

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