If there is one sector of the economy that is doing well these days, it is the outplacement industry. Those who provide career counselling to employees given the pink slip or an early retirement offer have seldom been busier. And, of course, these employees are also in need of specialized financial counselling to help them make the most of their severance packages. While there are some financial planners who practice almost exclusively in this area, most advisors will be called upon from time to time to help their regular clients who are going through a transition.
First of all, don’t make any assumptions about your client’s reaction to the severance. Even in tough economic times like these, not everyone will be devastated by losing their employment. In fact, if your clients have a solid financial plan in place, they may see a severance package as a windfall that will allow them to achieve some personal goals – taking some time off to care for children or an elderly parent, for example. They may not have quit their jobs to do these things, but with a severance package in hand, they are prepared to take advantage of the opportunity. Understanding their personal goals will help you tailor your recommendations accordingly.
Some companies offer a lump-sum severance payment, while others will maintain the employee on salary for a certain period of time. Occasionally, employees have the choice of how to receive their entitlement.
Taking the Lump Sum
A lump-sum severance payment is normally considered to be a retiring allowance and is taxable in the year received. For longer service employees, there is an opportunity to tax shelter some or all of this payment by transferring it to an RRSP, depending on their years of service with the employer paying the retiring allowance. The Income Tax Act allows for a transfer of $2,000 per year of service up to and including 1995 as well as $1,500 per year of service up to and including 1988 for which employer contributions to a registered pension plan (RPP) or deferred profit sharing plan (DPSP) have not vested. This transfer is over and above any regular RRSP room that the employee may have accumulated.
Since a retiring allowance is taxable as “other income,” it is not subject to CPP/QPP or EI deduction. Coverage under company benefit plans normally ceases once the employee is removed from the payroll, although some employers may compensate for this by including an extra amount in the severance payment.
Salary continuance payments are treated as employment income; therefore, all the usual deductions (CPP/QPP, EI, RPP) continue to apply. While there is no special provision for tax-sheltering as with the lump sum, the income received generates RRSP room according to the usual rules. The terminated employee continues to participate in benefit and retirement savings plans, with the exception of long-term disability insurance, which usually ends when the employee is no longer physically on the job.
Making the Choice
Here are some of the factors to consider when counselling a client on the choice between lump sum and salary continuance:
- How well does the client manage lump sums? Can he budget appropriately or is he likely to spend it all in short order?
- How does the opportunity for tax-sheltering compare between the two options?
- How important is benefits coverage for this particular client? Is comparable coverage available through a spouse’s employer?
- Are their strings attached to the salary continuance option, i.e., are the payments stopped if the client obtains other employment?
If clients choose the lump-sum option, you need to help them decide how to deploy the funds. Amounts transferred to an RRSP under the retiring allowance formula must either be transferred directly or within 60 days after the end of the year the client receives the payment. Deposits made to absorb regular RRSP room can be contributed at any time. If the client is going to need this money to cover expenses over the short term, it is often best to keep enough in cash to meet her needs for the required period. Many clients deposit as much as possible into an RRSP and then withdraw funds as needed. While this may be appropriate in some situations, they should be reminded that funds withdrawn from an RRSP cannot be replaced.
Additional tax-sheltering can be achieved by depositing $5,000 into a TFSA in the client’s name and $5,000 into a TFSA for the spouse or partner, if applicable. While the initial payment from the severance is taxable, the TFSA shelters the interest income earned on the funds. Funds can be withdrawn at any time and re contributed in future years.
Beyond these initial decisions, there are many other issues to consider – cash flow management, replacing lost insurance coverage and options for the funds in retirement savings plan. These will be covered in a future column.
If you have any questions, call Joseph A. Truscott at 905-528-0234 or email Joe at firstname.lastname@example.org.