Avoid Tax on Lump Sums on Retirement or Termination

Whenever possible, avoid adding a large lump sum to your taxable income in one tax year.  This can be especially problematic when a severance package or termination payment on retirement is received.

A better strategy is to arrange to take the money over two tax years; for example, consider taking part in December and part in January. That will often bring a better tax result over two tax years.

If your only option is to accept one lump sum, check out your RRSP contribution room and contribute as much of your severance to your RRSP as possible.  This will offset taxes owing on the severance in the current tax year. You’ll get to keep more money, earn investment income on a tax-deferred basis and reserve for yourself the opportunity to time RRSP withdrawals in the future to get a better tax result as a family. There may even be an opportunity to split RRSP withdrawals with your spouse in the future.  Also, check with a Tax Services Specialist to see if any of the money is eligible for a tax free rollover.

This is how Edward handled it: when he left his employer late in the tax year, he had already earned $65,000 for the year and received a severance settlement of $100,000.

Had Edward done nothing, the full $100,000 would have been added to his income, adding tens of thousands to his tax bill! To minimize the income tax consequences, Edward made an RRSP contribution of $100,000 (having not maximized his RRSP contributions in the past, he had sufficient RRSP contribution room). That eliminated the taxes.

If Edward needs to use those funds over the next several years, he could “average in” the taxes on the withdrawals by staying under the “top” of his marginal tax bracket. This strategy would again potentially  save Edward thousands of dollars.

Remember that any lump-sum withdrawal from an RRSP will be subject to withholding taxes; this must be taken into account in cash-flow planning.

Evelyn Jacks is President of Knowledge Bureau, home of the MFA-Retirement and Estate Planning Designation.  Call 1-866-953-4769 to register.

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