Your first instinct after receiving a severance package may be to seek legal
advice from an employment lawyer to determine whether your package was fair and
reasonable. But you should also consider getting some good tax advice to ensure
you maximize your after-tax severance proceeds.
Under the Income Tax Act, an amount that an employee receives "in respect of
a loss of an office or employment" is considered to be a retiring allowance and
is generally fully taxable in the year you receive it. In fact, your employer
has a legal obligation to make the necessary payroll withholdings of income tax
before giving you a cheque for the net amount. A retiring allowance is not
subject to Canada Pension Plan or Employment Insurance withholdings.
The Canada Revenue Agency has stated that payments in lieu of notice, such as
those made under the various provincial employment standards legislation, would
not qualify as a retiring allowance since the employee is legally entitled to be
paid during this minimum notice period and therefore, such a payment is more
properly classified as regular employment income.
The primary advantage of having your payment characterized as a retiring
allowance is that the "eligible portion" can be transferred to your RRSP, on a
tax-free basis, even if you don't have the available contribution room.
The eligible portion of a retiring allowance is calculated as $2,000 per year
of service before 1996, and an additional $1,500 per year (for a maximum of
$3,500) for service before 1989. The additional $1,500 is available to employees
who are not members of a company pension plan, or if their contributions to a
plan have not yet vested.
Note that the eligible amount must be transferred to an RRSP on which you're
the annuitant. You can't transfer an eligible retiring allowance to a spousal
RRSP.
What if you don't qualify for the rollover since you don't have years of
service prior to 1996? In that case, you can still contribute the non-eligible
amount to your RRSP to use up any outstanding contribution room you may have
from prior years.
Also, the amount may be transferred to either your own or a spousal RRSP. If
your employer contributes the non-eligible portion directly to an RRSP, you can
also avoid payroll withholding tax.
Another way to reduce the tax hit on a severance package, assuming your
employer offers some flexibility, would be to receive the severance over more
than one tax year.
Finally, keep in mind that any legal fees you pay to collect or establish a
retiring allowance may be tax deductible -- but only to the extent of the
retirement allowance included in your income.