In 2009 when the economy hit a downturn many employees lost their jobs. I personally know 3 people who were laid off during the downturn and it had a big effect on their finances (not to mention the emotional stress it caused since one was near retirement).
Now that the economy has somewhat recovered it isn’t as common as it was back then, but it does still happen.
Corporate restructures, mergers and downsizing can all lead to layoffs for long-time staff.
While you obviously can’t control how the economy will go in the future or how good the labor market will be, you can control what happens with a severance package offered by your employer.
Here’s a few things my colleagues did that helped them save on their taxes when they got laid off.
Lump Sum Payments
When employers offer an employee a severance package, it usually involves some form of payment. The longer the employee has been with the company, the higher the payment is likely to be.
One way you can avoid a huge tax bill is to avoid a lump sum payment whenever possible.
A lump sum payment given all at once will be taxed as income the year it is received.
This means if you receive a payment of $50,000, you’ll pay taxes on this amount on top of your regular earnings for the year. This could add up quickly, and your taxable income for that year could be significantly higher than expected.
Splitting of Payments
One way to lower your tax bill is to request that a severance payment be given over two years.
Of course, if you are laid off earlier in the year your employer will most likely want to make one payment to finalize things on their end as quickly as possible.
But if you get laid off near the end of the year there is no harm in asking if a severance payment (usually a lump sum) can be divided into two smaller (equal) payments – one in the current year and one in the following year.
Related: Common Tax Myths
By splitting the lump sum payment into two, you’d lower your tax bill because the second payment would be taxed when you receive it (in the following year).
For example: Let’s say you are offered a lump sum payment of $100,000 (a generous employer!). If you take the lump sum right away you’d pay about $26,500 in taxes.
If you split the lump sum into two payments of $50,000 each, you’d pay about $16,500 in taxes on both.
That’s a savings of 37% – even more important considering you are no longer employed and need to save whenever possible.
This is assuming you live in Ontario. Each province has different rates so the results may change but the basic idea is the same – two smaller payments are better than one large lump sum.
Let’s say you aren’t able to split a lump sum payment into two and are forced to take one large lump sum.
You can lower your tax bill by contributing as much as possible towards your RRSP (assuming, of course, you have the contribution room).
Let’s say you are given a lump sum payment of $40,000. Your normal salary is $80,000 and it’s near the end of the year so you’ve earned $70,000 so far.
Your employment income of $70,000 plus a lump sum payment of $40,000 means you’ll have a taxable income of $110,000 with a marginal tax rate of 43%.
But if you put $30,000 towards your RRSP, this would bring your taxable income down to $80,000 ($110,000 – $30,000) – with a marginal rate of 35%.
Conclusion: if you’re offered a severance package make sure you consider your options to see if you can lower your tax bill.
Three factors are important to consider: the timing of the income, other income earned in the year and RRSP contribution room.
Splitting a large lump sum into two smaller payments over two different years means you’ll pay less taxes overall. An RRSP contribution will lower your taxable income so it’s always a good idea (assuming you have the contribution room and can afford it).
The last thing someone thinks about when they get laid off is an RRSP contribution, but some quick planning can help you save big on taxes.
Related: The Ways We Overpay on Taxes