Severance Pay & Income Taxes

As with any payment associated with your employment, severance pay is subject to income tax; and the Canada Revenue Agency has provided its guidance with respect to how it intends to tax severance pay.

For purposes of income taxation, the payment structure by which the employee receives their severance pay has a significant impact on how the proceeds are taxed, which can be highly consequential.

1. Lump-Sum Severance Payment. If a terminated employee receives their severance pay as a lump sum payment, your employer will deduct income tax on that amount, based on taxing the employee for the full amount of severance pay, together with all employee pay earned in the year. Your severance pay, however, will not result in your employer deducting Canada Pension Plan (CPP) contributions, Quebec Pension Plan (QPP) contributions and Employment Insurance (EI) premiums.

2. Lump-Sum Severance Payments Transferred Directly into a Registered Retirement Savings Plan. If severance pay is provided as a lump-sum payment, with the option of transferring the payment directly to the employee’s Registered Retirement Savings Plan (RRSP) or Registered Pension Plan (RPP), the tax consequences will be substantially different. The terminated employee’s employer will not deduct income tax from the lump-sum payment, as the employee will only be required to pay tax on the money when it is withdrawn from the employee’s RRSP or RPP.

It should be noted that an employee must have enough RRSP contribution room available to transfer their severance pay directly into their RRSP. However, there is an exception for severance pay that applies to years worked before 1996. For that period, an employee can transfer up to $2000 per year directly into their RRSP without affecting their deduction limit.

3. Severance Pay Paid as Salary Continuance. Certain employers look to remit severance pay to their terminated employees by way of salary continuance, such that their regular salary and benefits continues to be paid for a set period after they’ve been terminated. As such, the salary continuance is subject to income tax, and relevant deductions, in the same manner as when the terminated employee had been employed. This includes usual deductions, for income taxes, CPP or QPP contributions, EI premiums and RRSP / RPP contributions.

4. Deferred Severance Payments. Employers may look to pay their terminated employees their severance pay over a period of two (2) or more years. This means that income taxes are deducted and due in the tax year that the severance pay is remitted to the terminated employee. By spreading out the remittance of severance pay over several years it may be possible to lower the amount of income tax owed by the terminated employee by not having the entirety of their severance pay received in a single year.

This represents some of the tax basics associated with various severance pay arrangements and income taxes, with more comprehensive aspects requiring further particulars and the engagement of knowledgeable professionals.

However, when your employment comes to an end, through firing, lay off or otherwise, the taxation of your severance pay is but a single aspect that demands consideration, with other elements being potentially far more consequential.

As such, you should be speaking with a knowledgeable lawyer to understand what you might very well be overlooking and realize the maximum amount from your prior employment, which is where our law firm can be of assistance. Contact us for a free confidential consultation to learn more, at Chris@NeufeldLegal.com or 403-400-4092 / 905-616-8864.