When you lose your job and receive a severance package, the last thing you want to worry about is paying taxes on the money you receive.
Unfortunately, the taxman considers severance packages as taxable income – which means you’ll have to pay taxes on it.
Severance packages are treated as lump sum payments by CRA just like an annual bonus (assuming it’s one payment). This means that your employer will have to withhold taxes on the amount they pay you.
How Much in Taxes?
How much you pay in taxes on a severance package is not a one-size-fits-all answer; it depends on your own personal situation – mainly your other types of income.
A severance package is added to your taxable income for the year, so how much taxes you pay ultimately depends on how much income you have in the year.
For simplicity, let’s say you have no other income in the year and receive a severance package of $40,000. If you live in Ontario you’ll pay about $5,800 in taxes. However, the withholding taxes for any amount over $15,000 are 30% (in this case $12,000) so the net amount you receive at first will be lower. Of course this can change with many other factors including any other income as well as your province of residence. Also, tax rates can change in the future which means you may pay more (or less) if they change.
It’s also worth nothing that almost no one has no other source of income in the year, so the marginal tax rate on the severance package is likely to be higher than if you had no other income in the year.
Timing a Severance Package
Even though a severance package is considered taxable, there are a few ways you can make the most of it.
The easiest way to maximize a severance package is to ask your employer to delay the payment or spread it out over multiple periods. As far as taxes go, receiving one lump sum payment could put you in a high marginal tax rate and should be avoided (if possible). Spreading out the payments over multiple periods means less withholding taxes are taken, but keep in mind when you file your tax return for the year it will all be taken into income for that year. The key is to have it spread out over two different years. This is much better tax-wise because it means you’ll spread the income out over two years and (potentially) pay less in taxes than receiving it in one year.
Another way to get the most of a severance package is to transfer the severance to an RRSP (Registered Retirement Savings Plan).
If you request your employer transfer the severance directly to your RRSP, no withholding taxes will be taken. This means you’ll get the full amount into your RRSP. You’ll still have to pay taxes when you withdraw the money from your RRSP though (at your marginal rate). This is more feasible for someone who receives severance midway through the year, as the employer isn’t likely to delay part of the severance for 6 months (or more).
You’ll want to make sure you have enough RRSP contribution room to make the transfer and the severance package must go into your own personal RRSP, not a spousal RRSP.
Salary continuance means your company will continue to pay your salary (as if you were working) for a specified period of time. Your regular payroll deductions would still apply – CPP, EI, withholding taxes and any other applicable deductions.
This option is better than a lump sum payment because it means you’re more likely to have some of the money spread out over two different years, which means your net taxes paid will be lower. The withholding taxes on each regular payment would also be lower than a lump sum payment.
Tips for a Severance Package
Regardless of how you receive your severance, there are a few things you can do right away to put yourself in a better position financially:
- pay off debt. Paying off any debt (especially high interest consumer debt) means you’ll have improved cash flows because you won’t have to worry about interest accumulating on the debt. This one is obvious and is the easiest thing to do.
- stash your cash. Another easy option is to put the money aside in a high interest savings account. If you don’t have any debt you should definitely consider putting some cash aside for the future.
- build your emergency fund. An emergency fund of cash should be easily accessible and a general rule of thumb is to save 3-6 months of net pay.
Conclusion: if you receive a severance package there are several options that may be available to you to minimize your taxes. The severance is still considered taxable income but you can still take some simple steps to keep your taxes as low as possible.
Note that the above is meant as a general guide and when in doubt you’ll want to speak to an accountant and lawyer about your own situation.