Severance Packages and Tax Minimization: A Guide for Ontario WorkersWritten on behalf of Peter McSherry
With springtime fast approaching and the calendar rolling into April, many people have income tax season on their minds. Preparing an annual tax return can be a tedious and complicated affair. This is especially true if your financial situation has changed significantly from the last time you filed or earned income from a new source.
This blog post will review the tax treatment of severance packages and offer tips for minimizing your taxes.
What is severance pay?
Severance pay is money that an employer pays out to an employee when the employee is terminated through no fault of their own.
Ontario’s Employment Standards Act (the “ESA”) sets out a formula for calculating how much severance pay an Ontario worker is entitled to. In general, a worker covered by the ESA is entitled to the equivalent of one week’s pay for each year of service, up to a maximum of 26 weeks.
Ways in which an employer may pay an employee severance
When you negotiate and settle a severance package with your employer, there are three ways for your employer to pay out severance:
- immediately, as a lump-sum payment,
- as a salary continuance, meaning that regular pay and benefits continue for a set period of time after the employee leaves the job, or
- as deferred payments, meaning the employee will receive their severance over several years.
It is usually the employer’s decision as to how they will pay out a severance package. However, in some cases, the employer may allow the employee to choose.
The tax treatment of your severance pay depends on how you receive it
Severance pay is taxable under Canada’s Income Tax Act (the “Act”). The rate of tax paid on severance depends on which one of the three options described above applies to the situation.
Taxes on lump-sum payments
A lump-sum payment (referred to in the Act as a “retiring allowance”) is when the employer pays the employee the total amount they are entitled to under the ESA in one large payment.
If an employee receives a lump-sum payment, the employer will withhold the income tax. The income tax withholding rates, combining the federal and provincial rates, are as follows:
- 10% on amounts up to and including $5,000;
- 20% on amounts over $5,000 up to and including $15,000; and
- 30% on amounts over $15,000.
Taxes on salary continuance
If severance is paid as a salary continuance, the employee will continue to receive their regular pay and benefits for a set period following employment termination. In this case, the employee will continue to pay income tax on their paychecks like normal. Salary continuance payments are subject to the same income tax deductions as well, including CPP, EI, and RPP contributions.
Taxes on deferred severance payments
Some employees may prefer to receive their lump-sum severance payment spread out over several months or years. In this payment structure, the employee will pay income tax only on the portion of the payment they receive in a given year. This can be an effective tax minimization strategy since the marginal tax rate will be less than if the employee had received the entire amount in a single year.
However, there are downsides and potential risks to receiving severance as deferred payments. An employee may lose out on the immediate income replacement benefits in the short term. Further, if the employer goes out of business before the employee has been fully paid out under the deferred arrangement, recovering the outstanding amount may be challenging, if not impossible.
Minimize taxes by transferring your severance to an RRSP
One of the most effective ways to reduce the amount of income tax you pay on a severance package is by asking the employer to transfer all, or a portion of, the lump-sum payment to an RRSP account. This means that the employer will not withhold income tax from the payment. Instead, the employee will pay tax on the amount when it is withdrawn from the RRSP. Additionally, RRSP contributions are deductible from income for tax purposes.
To use this strategy, an individual must have sufficient RRSP contribution room available to transfer the severance payment to the account. However, for severance pay that applies to years worked before 1996, up to $2,000 per year may be transferred directly to an RRSP without affecting the contribution limit.
A severance package may include non-taxable receipts
It may be possible to structure a settlement package such that the employee receives a portion of it as “general damages.”
General damages are payments from an employer that are unrelated to the loss of employment. This may include things like damages for a personal injury, harassment, emotional distress, or a human rights violation. Such damages are non-taxable.
It is not always clear-cut as to when damages are connected to the loss of employment, so it is important to seek legal advice to confirm whether this applies to your unique circumstances.
It is a good idea to seek the help of a legal professional
The tax implications of severance packages can be complex. Every situation is unique, and each employee’s needs differ from their co-worker’s. That is why having an experienced employment lawyer guide you throughout the entire process is important. Not only can a lawyer ensure that the employee receives the compensation they are entitled to, but they can also help negotiate a fair settlement package that is structured to minimize any tax burdens.
Contact the Employment Lawyers at Peter A. McSherry in Guelph for Guidance on Negotiating Severance Packages
No matter how good a severance agreement sounds, it is always wise to review the agreement with an experienced employment lawyer. The trusted employment law team at Peter A. McSherry Employment Lawyers can help you negotiate all aspects of your severance package and can advise on matters such as tax minimization. Reach out to our team online or by phone at 519-821-5465 to schedule a confidential consultation.