Dealing With Your Severance Allowance

Last week we looked at Tony who was let go from his company after 25 years of service. Let’s look at Tony’s situation in a little more detail.

Tony’s severance was $80,000, which was roughly 12 months salary. On top of that, Tony will get about $10,000 for vacation and sick days. His termination was effective November 2001.

Rolling the severance to RRSPs

In 2001, Tony worked for 11 months before being let go which means his T4 slip for the year would be about $73,000. This puts Tony in the 36% marginal tax rate (in Alberta). If he takes the severance in cash, he would add the $80,000 to his existing $73,000 income and be taxed at the highest marginal tax rate. Tony would lose $30,390 to taxes on the $80,000 severance.

To avoid this tax, Tony should consider a rule that permits a rollover of up to $2,000 for each year (or partial year) of service prior to 1996 to the RRSP. He could also transfer an additional $1,500 per year of employment prior to 1989 where he was not part of the pension plan.

Tony started working for the company in November 1976. He started from the ground up as a Customer Service Representative. Although he worked for the company for 25 years, he was only part of the pension plan after becoming management in April 1991.

According to these rules, Tony would be able to rollover $59,500 to his RRSP without tax on top of his current RRSP limit ($2000 X 20 years = $40,000 plus $1500 X13 years = $19,500).

Now, if Tony rolls this amount to the RRSP, he will only pay tax on the difference of $20,500 ($80,000 minus $59,500). His tax bill would reduce from $30,390 to $7380. That’s significant.

Spread the severance over calendar years

Severance or retiring allowance is taxed in the year that the terminated employee receives it. One of the thoughts Tony should entertain is requesting his employer spread the severance over a number of calendar years.

If Tony’s employer pays out the balance of the severance on January 1, 2002, instead of November 30, 2001, the $20,500 would be taxed in a new calendar year. Instead of being taxed in a 36% marginal tax rate, the $20,500 would be taxed starting from ground zero.

Simply delaying the severance for one month could save Tony another $3000 in taxes leaving his final tax bill to only about $4500 on the $80,000 severance.

Keep in mind that if Tony starts working again in 2002 his severance that was pushed to the future year might be taxed at a higher rate. As long as he earned less than $40,000, he would be better off delaying the severance to 2002.

Vacation and sick pay does not qualify under the rollover provisions.

Make up your unused RRSP contributions

Up to this point, the RRSP rollover is in addition to your normal RRSP contribution limit. In Tony’s example, he has about $5,000 that he can contribute to an RRSP. He can request that the employer transfer $5,000 of the remaining $20,500 to an RRSP with no tax held at source. This would then leave only $14,500 in a taxable environment.

For the regular RRSP contribution, Tony could invest that into a spousal RRSP but for the rollover, he can only roll the severance to his personal RRSP.

What if Tony needs income?

Tony is not ready to retire. He plans to take about 6 months off before looking for another job. He figures he will need about $3,500 per month (after tax) to make ends meet. Tony could easily take money out of his RRSP to supplement his income needs if necessary. So what’s the point of moving money to the RRSP only to take it out again? Moving money to the RRSP not only gives you maximum tax deferral but it also gives you the most flexibility and control.

What if Tony went back to work sooner than planned? What if he went back part time instead of full time? In both cases, he might not need to supplement income and thus he could avoid having to pay tax by leaving the funds in the RRSP.

For most people, it would be in their best interest to roll as much of this pay out into the RRSP for maximum tax deferral. If the future is uncertain, just invest the funds into a money market fund for the short term until you have a clearer future mapped out.

I used a specific example to try to walk you through some of the different options available to people who are facing this issue. Remember that everyone’s situation is unique and there may be times where it will not be in your best interest to move money to the RRSP. If you are unsure, seek help from a financial advisor who can help you look at the bigger picture. Next week, we will tackle the pension plans.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace.For more information you can follow him on Twitter @JimYih or visit his other websites Group Benefits Online and Advisor Think Box.

4 Responses to Dealing With Your Severance Allowance

  1. The $1500 per year of employment prior to 1996, is it:
    years of employment. Period.
    OR,
    years of employment in this company (my last employer)?

    Please e mail me the reply.

    S.E.

  2. I am completely confused. I recently retired from the Military, and started looking for work in the private sector. I received a $45000 dollar severance package, which is took a portion as a cash pay out, $14999, in event a financial situation arose. I paid roughly 30 percent tax on the portion which I took, and the remainder was rolled into an RRSP. I secured a wonderful job and started receving pension, plus a salary. If I understand what you are saying, the $30000 should be rolled into the RRSP, $14,999 would be added to my income. However, when my taxes were done, I had a receipt for the $30000 RRSP contribution, but received a T4 which showed the taxes paid, line 66 and 67, eligible retiring allowances and non eligible amounts, which were added together and reported as other income under line 130. When this was done, it pushed me into an entirely new tax bracket, plus I did not pay any taxes on $30000 of income at a much higher rate. I contacted CRA, and they say yup, thats the way it is? I also contributed an additional $15000 after the fact, and still ended up paying a huge tax bill. I am confused if the contribution, is actually other income?

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