Tax Planning with Severance

Ruth Horst & Evelyn Jacks

According to a Statistics Canada report on March 31 labor market trends, job losses are starting to occur in Canada, for the first time in 26 months, with the unemployment rate ticking up to 6.7%.  Some of this can be attributed to tariff uncertainty.  But, amongst the 1.5 million unemployed people in Canada, 44% lost their jobs due to a layoff in the last 12 month and that means, doing a T1 return for 2024 will require specialized knowledge in reporting severance.  Here’s a primer on what to know:

Severance packages can range from five to six figures, and the decisions your clients make with this money are crucial. For some it’s the largest, and sometimes their last pay cheque in their career.  The tax consequences can take away a lot of this – in some cases more than 50% - because most severance packages will be fully taxable in the year received. Use the following lines of defence:

1. The first line of defence is to consider whether the severance can be received over two tax years – 2025 and 2026 for example.  This works best when the layoff comes late in the year.  

2.  The second  line of defence  is to consider contributing as must as possible to an RRSP to reduce the tax liability and ensure available refundable tax credits become available to the family. 

How much RRSP room is available? Check it out, reduce the tax hit, and then make an orderly monthly withdrawal to pay for immediate costs.  The RRSP withdrawal will be subject to take in 2025 and don’t forget there is withholding tax on the withdrawal as well.

Here’s what will be deducted:

10% -  withdrawals up to $5,000 (19% in Quebec) 

20% -  withdrawals between $5,000 up to $15,000 (24% in Quebec)

30% -  withdrawals over $15,000 (29% in Quebec)

Remember you can also withdraw on a tax deferred basis if you decide to upskill by going back to school under the Lifelong Learning Plan (LLP). The basic rules are:

·      You can withdraw up to $10,000 in a calendar year to finance full-time training or education

·      You can withdraw for your own education or that of your spouse or common law partner but not your children.

·      You can withdraw every year until January of the fourth calendar year after the year you made your first LLP withdrawal, if you continue to qualify.

·      The maximum withdrawal that can be made is $20,000 in total

·      You have to repay 1/10 of the total withdrawn annually over a 10-year period

·      The latest you can start repaying is the fifth year after the first LLP withdrawal.

Rollovers.   When it comes to severance payments, the availability of tax-free rollovers is highly dependent on the number of years of service and the specific timing of that service.

The CRA has ruled that any portion of a year, even if it's just one day, counts as a full year of service. However, it’s important to note that payments for service performed after 1995 are not eligible for rollover. This means that for many individuals, no tax sheltering is available for more recent service, making the timing of these payments crucial.

Tax-free rollovers are available for service provided before 1996, with an eligible portion of the retiring allowance being $2,000 per year or part-year of service. Additionally, an extra $1,500 per year can be transferred for any year before 1989, provided the employer’s contributions to an RPP or Deferred Profit Sharing Plan (DPSP) had not vested in the employee.

Whenever possible, consider advising your clients to take a portion of the severance in one tax year and the rest in the following year. This strategy is particularly useful if the severance package is received near the year’s end, as it can help to spread out the tax liability and avoid the full severance amount being taxed at higher marginal rates in a single year.

For clients nearing retirement, there may be an opportunity for a tax-free rollover of severance funds into a Registered Pension Plan (RPP) or an RRSP. This could create pension income-splitting opportunities down the road. For RPPs, pension income splitting is available at any age, but for RRSPs, it’s not available until the conversion to a RRIF at age 65.

One final point to consider: if interest is paid on a deferred severance payout, that interest is not part of the retirement allowance and, therefore, isn’t eligible for a rollover. However, payments for unused sick leave credits do qualify as a retiring allowance.

Bottom Line.  When job loss occurs speak to a tax and financial planning specialist first.  There are employee counselling support payments possible in some companies for these purposes.