Is Severance Pay Taxable in Canada?

Yes, in Canada, severance pay is taxable income in the year it is received.

This means that the amount you receive as severance will be added to your annual income and taxed at the same rate as if you had earned it through regular employment. 

This fact should be considered when planning for your future financial situation post-employment or transitioning to a new job or career. 

In this article, we breakdown severance pay details, how much it can be, and how you can decrease your payments

Key Takeaways

• Learn what a severance pay is.
• Understand how much lump sum payment you must make as a severance payment.
• Discover how you can decrease the tax on severance pay.
• Uncover the additional tips when your severance pay is taxable.

What is Severance Pay?

Severance pay, or termination pay, is compensation provided to an employee upon termination, typically due to downsizing, restructuring, or other circumstances beyond their control. 

Severance pay is a financial cushion that helps bridge the gap between jobs and ease the transition into new employment. To qualify for severance pay, an employee must have worked for the same employer continuously, often for 12 months or more.

This payment can take various forms, including employment income, retiring allowance, non-taxable damages, and sometimes a combination of these categories. 

The classification of severance pay directly and regulations vary across jurisdictions governed by provincial, territorial, and federal employment laws. Whether severance pay is outlined in an employment contract also depends on individual circumstances.

In some cases, severance packages in Canada may encompass additional benefits the employer provides, adding to the overall compensation package.

Employment Income:

This is the most common form of severance pay and is subject to the highest tax bracket. It can be disbursed as a lump sum or through salary continuance.

Retiring Allowance:

Reserved for recognition of long service, retirement allowance cannot be granted before retirement and must be associated with a loss of income.

There are options to transfer this allowance directly to registered retirement savings plans (RRSPs) or registered pension plans (RPPs), subject to specific contribution rules.

Non-Taxable Damages:

These damages are awarded for reasons unrelated to employment, such as work-related injuries that do not cause unemployment. This form of severance pay is not taxed.

How Much Can You Expect to Pay in Taxes

The taxes you'll owe on your severance pay depend on several factors, including your total annual income and tax bracket. In Canada, income tax is progressive, meaning that the more you earn, the higher your tax rate.

Simply put, you'll pay more taxes if you get a large amount. 

Similar to taxes on bonuses, understanding your tax bracket and how severance pay impacts your overall income can help you better anticipate your tax liability and plan accordingly. 

For instance, if you're getting severance pay as employment income, your employer might have tax on severance pay in one of the two ways below, and they can be taxed differently:

Integrated with Regular Wages:

If your severance pay is included in your regular wages, the same tax withholdings that apply to your normal paycheck will also apply to your severance payment.

This includes income tax based on your T4 slip and benefit return, like social insurance and healthcare for the year, under Tax Folio S2-F1-C2.

Separate from Regular Wages:

Alternatively, a 10–30% (or 5–15% for Quebec) withholding rate for federal income tax usually applies if your severance pay is issued separately from your regular wages.

This rate substitutes the typical federal tax withholdings based on your T4 slip.

In another case, specific withholding tax rates apply if you receive your severance pay as a retiring allowance. Here's a breakdown of pay tax here:

According to the Income Tax Act, a payment qualifies under income tax act as a retiring allowance if it meets either of the following criteria:

1. Received upon retirement from an office or employment, recognizing the individual's long service.
2. Received concerning the loss of employment, regardless of whether it's received as damages or under an order/judgment of a competent tribunal.

The Canada Revenue Agency (CRA) specifies that for a payment to be considered in respect of tax treatment of a loss of employment:

1. It must be specifically for the loss of employment.
2. There must be evidence that the loss of office is not speculative.
3. The termination of employment, including benefits, must occur on a specific date within a reasonable timeframe.

The Tax Court of Canada outlined a two-step test for that:

1. Would the employee have received the payment if not for the loss of employment?
2. Was the payment intended to compensate for the loss of employment?

If the answer to the first question is no and the second question is yes, then the payment qualifies as a retiring allowance. Unlike employment income, retiring allowances are subject to lower withholding tax rates:

• Up to $5,000: 10% tax rate
• From $5,000 to $15,000: 20% tax rate
• Over $15,000: 30% tax rate

Note that these withholding tax rates serve as an estimate, and your actual tax liability will be reconciled when you file your annual tax return. This makes tax planning crucial when managing your severance pay and is also why you should consult an HR agency or your company's HR department.

How Can I Decrease the Taxes I Pay on Severance? 

While the taxation of severance pay may seem like a financial setback, there are strategies you can employ to minimize the amount of taxes you owe.

Here are a few options to consider:

1. Canadians can purchase RRSPs 

One option is to use a portion of your severance pay to contribute to a Registered Retirement Savings Plan (RRSP). RRSP contributions are tax-deductible, meaning they can reduce your taxable income for the year. 

An employee with their employer since 1995 might be eligible for a retiring allowance. This allowance could enable them to contribute more to their RRSP beyond their standard RRSP contribution room.

However, remember that funds contributed to an RRSP are not meant to be withdrawn until retirement, so this pension plan may not be the most flexible option for everyone.

2. Deferred severance payments 

Choosing deferred payments can provide the highest income tax benefits, although not all employers provide this option for severance payments.

Deferred payments involve spreading your severance payout over 1-2 years, offering a tax advantage. By distributing the income across multiple years, you may fall into a lower marginal tax rate bracket each year, reducing taxation overall.

However, it's essential to note that deferred severance payments might lead to interest in some cases. If your deferred severance earns interest, you'll be taxed on this interest as if it were additional income. Consult an expert to help you consider this option and negotiate with your company.

3. Salary continuance payments 

Another option is negotiating with your employer to receive salary continuance payments instead of a lump sum severance package. 

With this approach, you would continue to receive regular paychecks for a specified period following your termination, mimicking the income stream you received while employed. This can help replace employment income, reduce the tax burden, and provide financial stability during your job transition.

Additional Tips While Experiencing Employment Loss

It's essential to be aware of other potential sources of income that may impact your tax situation during employment loss. For example, holiday or sick leave included in severance pay and receiving a lump sum can lead to higher taxes.

Here are some tips to avoid that scenario:

Holiday and sick days pay

Some employers may pay out accumulated vacation or sick leave as part of your severance package, which can unexpectedly increase your annual taxable income. In that case, avoiding a lump sum payment is better because it will take away more from your payment than benefit you.

Consulting with a tax professional can provide more accurate projections and help you navigate these complexities.

A higher tax bracket 

It's also worth noting that receiving a large lump sum of severance pay could raise your tax bracket. 

However, it's essential to understand that only a portion of your income within the higher income tax bracket will be taxed at the increased rate. This is known as marginal tax rates and is a key concept to grasp when considering the tax implications of severance pay.

In this case, it may be beneficial to contribute to RRSPs.

Final Word 

While the taxation of severance pay may seem daunting, understanding how it's taxed and exploring potential strategies to minimize your tax liability can help ease the financial burden during a challenging time. 

By staying informed and seeking professional guidance when needed, you can navigate the complexities of severance pay taxation with confidence and peace of mind.