You and your Severance
When employees receive termination notices, one of the most common thoughts is, “How will I pay the bills?” Severance, early retirement, extended layoff? Transitions like these can be stressful, but with planning, good advice and focus, you can cushion the blow and open doors to the future. Along with your financial advisor, you can make the most of a tough situation.
3 steps to putting your money to work
- Step 1 Objectively review your situation
- Step 2 Minimize the tax you pay, so that you can build a strong financial foundation
- Step 3 Put your money to work by investing wisely
Review your situation
This is the time to call your financial advisor to review you’re overall financial and investment plan. Your advisor can keep things in perspective and provide objective advice at a critical time. Here are some points to consider in your meeting:
A look at your balance sheet will let you determine whether you need to find new employment right away. It may also help you to see that you can take some time out of the job market, or even retire. An advisor can help you to assess your options as part of your overall plan.
- If you have a spouse or partner, will he or she be bringing in any income?
- Review your assets and debts and estimate how much cash you will need in the short term and long term
- Will your salary and benefits continue for a number of months, or will you be receiving a lump-sum payout? Salary and benefits continuance can help you budget over the continuance period. If your benefits cease and you receive a lump sum on the other hand, you will have to create a more detailed plan.
- Will you need extra funding for health or insurance coverage that was covered by your employer?
- How much of your severance will you need or want as liquid assets to pay bills, take a vacation or make a special purchase?
- Do you have a pension plan that will provide income? When does it start?
- Do you have other assets set aside for retirement already, such as an RRSP?
- Do you have any loans outstanding that you may be required to pay back to your former employer?
What monies can you expect?
Under Canadian income tax rules, a severance or retiring allowance is generally made up of termination pay that is provided either voluntarily by a company, prescribed under provincial laws, or in some cases, is the result of a court settlement. You may receive one or a combination of any of the following:
- Severance or termination pay
- Long service pay
- Unused sick leave credits
- Unused vacation pay
- Bonus pay earned but not yet paid
For tax planning purposes, it is important to know which payments are classified as “employment income” and which are considered a “retiring allowance”. Compensation for unused vacation time, bonuses earned or payment in lieu of notice is “employment income”. That means that these payments are taxable to you in the year they are paid. The other payments are “retiring allowances” which can be tax-deferred in certain circumstances. The following example will help clarify the tax rules.
Renée had been working for XYZ Corporation since 1982, and was terminated in July 2010 when XYZ Corporation closed its operations. XYZ did not have a pension or deferred profit sharing plan. Renée received the following monies:
Termination Pay: $65,000
Unused sick leave credits: 2,000
Unused vacation pay: 1,500
Total payout: $68,500
Since unused vacation does not qualify as a retiring allowance, Renée must include the $1,500 vacation pay as income, and pay tax on it in 2010. The balance of $67,000 is eligible for direct transfer to Renée’s RRSP within the transfer limits. If taken in cash, Renée will have to include the full amount in income in the year received, which will likely push her into a higher (and therefore more expensive) tax bracket.
Effective tax-planning techniques can minimize the tax consequences of severance monies, thereby increasing family after-tax income. Consider the following strategies with your advisor:
- Direct transfer to your Registered Retirement Savings Plan (RRSP)
If you receive a retiring allowance, you may be able to transfer some or all of the allowance directly to your RRSP without any income tax withheld by your employer. This can minimize the tax payable by you on the severance, and does not require you to have any unused RRSP contribution room. The maximum amount eligible for direct transfer to your RRSP is as follows:
- $2,000 per year or part year of service with your employer before 1996, plus
- An additional $1,500 per year or part year for years of service prior to 1989, for which employer pension plan or deferred profit sharing plan contributions, if there were any, were not yet vested. “Vested” means that you are entitled to take these contributions with you when you retire or terminate, usually after a specified waiting period.
Depending on how long you worked for your employer, these rollover rules may or may not apply to you. If you were employed in 1996 or later, the amount you receive will not qualify for tax-deferred transfer.
Renée can shelter her retiring allowance from tax by transferring the eligible amount directly to her RRSP. The maximum amount eligible is calculated as follows:
14 years of employment before 1996 ($2,000 per year of service x 14) $28,000
7 years of service before 1989 ($1,500 per year of service x 7) 10,500
Total eligible for a tax-deferred transfer: $38,500
The remaining $28,500 plus the $1,500 vacation pay will be subject to tax, unless Renée has $30,000 in unused RRSP contribution room available. If so, Renée can make a taxdeductible contribution to her RRSP, or to a spousal RRSP.
- Take your retiring allowance in installments
If you don’t need all of your retiring allowance at once, and your employer agrees, you may want to consider receiving monies in installments over more than one year. This strategy works best if you are near the end of the year (for example one-half paid in 2010 and the other half in January of 2011), as it can benefit you by splitting the taxable income over, usually, two tax years
Renée decides to spread her retiring allowance over two years – half in August 2010 and the remainder in January 2011.
Taxable Portion in 2010 ($67,000 x 50% plus $1,500 vacation pay) $35,000
Taxable Portion in 2011 ($67,000 x 50%) $33,500
The tax slips you will receive
Your employer will prepare a T4A tax slip for you that will indicate what amounts are eligible for the RRSP transfer. You will have to report the full amount of your retiring allowance from box 26 and box 27 of the T4A on your annual tax return. If you transfer the eligible portion directly to your RRSP, your employer is not required to withhold any tax at source. This will allow you to maximize the rollover amount for your
Now that you have received unexpected monies, review your investment objectives and make sure this money is put to its best use for your future. Here are some important questions to consider:
A financial advisor can help you select the best investments for your portfolio. You will also be able to use a “Tax-Free Savings Account” (TFSA) to shelter up to $10,000 annually.
Severance can be a stressful time, but it can also open up opportunities. Proper planning can bring you peace of mind – and get your money working, even when you are not. A financial advisor can help you manage your financial affairs to fit your lifestyle and personal needs, now and in the future.