Every recession brings significant job losses. If any of your clients have become unemployed recently, help them sort through the various decisions that must be made to ease both immediate and long-term financial burdens.
Compensation stemming from job loss is generally salary continuance or a retiring allowance. Salary continuance (including accumulated vacation pay and pay in lieu of reasonable notice) is considered employment income and is therefore subject to the same source deductions as regular salary (including tax, CPP and EI). In addition, it’s generally accompanied by other employment benefits, including health and insurance benefits, as well as continued accrual of pension benefits. Continuation of benefits after job loss can be very important.
If severance is a one-time payment or a fixed amount payable over a short period with respect to loss of employment, or after retirement in recognition of long service (without continuation of employment benefits), it’s considered a retiring allowance. Retiring allowances are fully taxable in the year received. However, a portion may be eligible for transfer to the recipient’s RRSP, resulting in a deferral of tax on the amount transferred.
The severance amount eligible for transfer to an RRSP is limited to $2,000 per year of service with the employer, or a related employer before 1996, plus $1,500 for each year of service before 1989 for which employer contributions to an RPP or DPSP have not vested. The employer computes the amount eligible for transfer and reports it on a T4A slip.
This special deductible RRSP contribution can be made as a direct transfer of the eligible termination payment by the employer, as instructed by the employee. The benefit of the direct transfer is that tax withholding at source is not required.
Alternatively, the employee can receive the retiring allowance and then transfer the eligible portion to his or her RRSP up to 60 days following the end of the year in which the payment was received. In this case, the employer must withhold and remit income tax on the retiring allowance paid. And although the employee is entitled to a deduction in relation to the amount contributed to the RRSP, the tax benefit will not be gained until the tax return for the year is assessed—and that could be more than a year later.
Individuals who receive retiring allowances should be reminded that if this special contribution is not made within 60 days of the end of the year, the related contribution room cannot be carried forward. Also, these special RRSP transfers can only be made to the employee’s own RRSP, not to a spouse’s plan.
To reduce the tax bite of a large severance package—if the retiring allowance is significantly greater than the portion eligible for RRSP transfer, and if the individual has other unused contribution room—he or she might consider using some of the ineligible retiring allowance amount to fund RRSP contributions. Significant tax benefits are available if the retiring allowance would otherwise be taxed at the highest marginal rate.
An employee might attempt to negotiate receiving the payment in instalments over more than one year. This provides access to the lower marginal rates in the subsequent year, but it also means the person won’t have access to the funds until that time.
The strategy is only effective if the employee exercises the instalment- payment option on or before the employment is terminated, and if there are no other significant income sources in the year following termination.
Finally, if an employee incurs legal fees to secure a severance, these fees are deductible, but only against the severance or termination payment reported, net of amounts transferred to an RRSP.