Whether you give up your job or lose it, taking the wrong steps afterward could cost you money
By Olev Edur
If you’re about to retire from a job you’ve had for a long time, you may be entitled to a substantial severance payment—a “retiring allowance,” as Canada Revenue Agency (CRA) calls it—in recognition of that long-term service. If so, you should be aware that special tax rules may apply to some of the money you receive. You should also be aware that this tax provision was expanded in 2016 and may apply whether you’re actually retiring or not.
In fact, the same rules apply to such payments even if you quit your job or are fired and then move to another job with a different employer. According to CRA’s Income Tax Folio S2-F1-C2, Retiring Allowances, “CRA considers the termination of employment for any reason as being retirement or loss of employment for the purpose of determining whether an amount qualifies as a retiring allowance.”
The Income Tax Folio document goes on to state that a retiring allowance may include payments for unused sick leave, as well as amounts that someone receives when his or her office or employment is terminated, “even if the amount is for damages (wrongful dismissal) pursuant to an order or judgment of a competent tribunal.”
While Amy Dietz-Graham, an investment advisor and portfolio manager with BMO Nesbitt Burns, acknowledges the seemingly all-encompassing nature of CRA’s definition of a retiring allowance, she says that that isn’t always synonymous with a severance package.
“One issue we encounter in working with clients is that the terms ‘retiring allowance’ and ‘severance pay’ are used interchangeably, and that can cause confusion,” she says. “In reality, a retiring allowance can be just one element of a broader severance package. For example, a severance package could include unused vacation pay or bonuses, which don’t qualify as a retiring allowance. Sometimes an employer will offer benefits such as job counselling when an employee is let go, but these benefits don’t qualify as a retiring allowance, either.”
Is It or Isn’t It?
So, how do you know what does qualify? According to the Income Tax Folio document, one key determinant is whether you continue to work for the employer who is paying the severance, and this in turn has been determined by the courts to depend on the circumstances.
“The fact that an individual continues to participate in a health or dental plan of a former employer would not, on its own, indicate that the individual has not retired, as it is relatively common for such plans to provide coverage to retirees,” the document states. “However, if the individual continues to accrue pension benefits, this would indicate a continued employment relationship, as pension benefits accrue only to employees.”
That an employer doesn’t require someone to report to work does not indicate that the person has retired. “For example, an individual who has been given a leave of absence for educational purposes is still an employee,” according to the document. It also states that the courts have boiled the issue down to two questions:
- But for the loss of employment, would the retiring allowance have been received?
- Was the purpose of the payment to compensate for a loss of employment?
Only if the answer to the first question is No and the second is Yes will the amount be considered a retiring allowance.
So, for example, a payment for unused sick-leave credits qualifies as a retiring allowance when the payment is received on or after retirement in recognition of long-term service or in respect of loss of employment. However, a payment for unused sick-leave credits received while employed is considered employment income. “If an individual continues to earn salary and benefits until a date after the date they cease to report to work, the retirement or loss of employment, as the case may be, is considered to take place only at the later date,” the document states.
Retiring allowances have to be paid at or after retirement, but that’s not so for payments due to loss of employment. These can be made in advance and still be considered retiring allowances provided that they are, in fact, due to losing your job, and that the job and any related benefits terminate on a specific date and within a reasonable period of time.
Specialized Tax Treatment
Normally, a retiring allowance must be included in income in the year it’s received. That means it will be taxed at your top marginal tax rate and, if it is a substantial amount, the result could be that the government can claw back as much as half of what you receive. There is, however, a relief provision in the tax rules that may enable you to transfer part of the payment into your RRSP (but not a spousal RRSP), pension plan, Saskatchewan Pension Plan (SPP), or pooled registered pension plan (PRPP).
Specifically, the rules allow you to transfer the “eligible” portion of the payment, which is defined as:
– $2,000 for each year before 1996 during which you were employed by the paying employer (or a person related to the employer), plus
– $1,500 each year before 1989, provided no employer contributions to a pension plan or deferred profit sharing plan (DPSP) vested in the employee that year. (Employers often make contributions to such plans, but they don’t actually belong to the employee until they become vested, typically after a fixed period of employment such as five or 10 years.)
If you receive a T3 slip, the eligible portion is reported in box 47; if you receive a T4, the eligible portion is shown in box 66. For 2009 and prior years, the eligible portion is shown in box 26 of your T4A slip, or your T3 slip shows the eligible portion of your retiring allowance. You must report the total payment on line 130 of your tax return for the year, but then you can claim a deduction on Line 207 for a transfer to your registered pension plan (RPP) after entering the amount on the appropriate line(s) of Schedule 7.
Any transfer of funds to a qualifying plan must be made in the year the retiring allowance is received (or within the first 60 days of the following year). You can transfer the funds yourself once you receive the money, or the employer can do it directly. In the latter case, no tax will be withheld at source, whereas if you take the cash, it’ll be subject to withholding tax. A direct transfer by the employer is therefore generally the preferred option.
Either way, a retiring allowance transfer will have no effect on your contribution limits to the RRSP, PRPP, or SPP. In other words, if you have any contribution room left, you can also contribute ineligible parts of the allowance to your own plan or to a spousal plan, up to the amount of your available RRSP/pension contribution room. And again, no tax will be withheld if you have your employer contribute directly on your behalf, although in this case you’ll need to tell the employer how much can be contributed based on your available contribution room.
Dietz-Graham cautions, however, that you should double-check with the financial institution to ensure any transfer is actually recorded as a transfer and not as a contribution. “You need to make sure the amount does get transferred as a retiring allowance,” she says. “We often see errors where the amount goes in as a contribution; in that case, you would lose that contribution room unnecessarily.”
Finally, as for what to do with the money once you’ve received and allocated it to the appropriate accounts, Dietz-Graham stresses the importance of speaking to your financial advisor about your intentions.
“In most cases, it’s best to put as much as you can into RRSPs [or other qualifying plans], but if, for example, you have a lot of debts, it may be better to pay the tax and use the cash to pay down the debt.
“Looking at the broader picture, you should definitely consult a financial planner when you retire, because retirement involves a major lifestyle change,” Dietz-Graham adds. “You need to make sure the money is properly allocated and, unless you have a lot of debt, that it’s properly invested in a diversified and balanced portfolio based on your needs and your risk tolerance.”