Retiring from a job that you held for many years or losing your job due to downsizing may entitle you to receive compensation in the form of severance pay, also called a retiring allowance.
According to Jeff Duguid, CPA, CA, a seasoned personal income tax preparer in Osoyoos, “severance pay is money and benefits you may be entitled to if you are let go without cause. Termination pay is not severance pay.” Severance pay is reported on Line 130 of your tax return.
Taxable as Income
You may choose to receive the severance pay directly as a lump sum. In this case, the amount should be included in the income you report on your tax return. Tax will be deducted from the severance pay if it is paid directly to you, because your former employer is obliged to withhold an amount for tax.
“Severance pay is taxable when received and is subject to withholding tax rates between 5 percent and 30 percent, depending on the province that you reside in and the amount of the severance,” says Duguid.
Transfer of Eligible Severance Pay
With planning, you may be able to reduce the amount of tax payable on the severance pay. “You can avoid the withholding tax by choosing to transfer the severance allowance directly into your RRSP or RPP,” Duguid points out.
Transferring into a registered retirement savings plan or registered pension plan shelters the money from tax by reducing your taxable income. How this affects your RRSP deduction limit depends on how much of the severance pay is designated eligible.
The eligible and non-eligible portions are shown on the T3 or T4 slip given to you. “For a portion of your severance pay to be an eligible retiring allowance, the severance payment received has to be for your employment services prior to 1996,” says Duguid.
The eligible amount can be directly transferred to your RRSP, without affecting your RRSP deduction limit. It is akin to being allowed extra RRSP contribution room.
That means you can transfer all of the eligible portion of the severance pay into your RRSP, even if you have no deduction room left.
However, the eligible portion cannot be transferred to your spouse or common-law partner’s RRSP.
In addition, persons older than 71 years of age at the end of the tax year are not permitted to transfer any portion of a retiring allowance into their own RRSP.
Non-Eligible Severance Pay
If you don’t have employment service years prior to 1996 that are applicable to the severance payment, the severance pay will be non-eligible. Non-eligible severance pay still may be transferred directly into an RRSP to shelter it from tax, but only if you have contribution room left.
You also may transfer it to a spouse or common-law partner’s RRSP if she has enough contribution room. Any amount left over will be subject to tax.
You may be eligible for other deductions if you have non-eligible severance pay. “Legal fees incurred to collect or establish your right to a severance payment can be tax deductible to the extent that the severance payment itself is not sheltered by transfers to your RRSP or RPP plan,” notes Duguid.
Be sure to obtain detailed receipts from your lawyer if you went to court to get severance pay.
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