One of the most common questions I have been asked in the past year by employees of the Canadian Federal Government is; “what do I do with my severance pay?”
The recent collective agreement reached by the government of Canada entitles employees to receive up to one week's pay for each year of continuous employment (up to a maximum of 30 weeks). For some, this represents quite a nice chunk of change! Let’s explore the options you have to get the most out of this payment.
Use Your RRSP to keep more money away from the Tax Man: If you decide to cash out the amount before retirement your only option for saving money is a contribution to your personal RRSP. Use the maximum of your contribution room to save taxes on most of the severance payment as possible. If you wait until retirement, you can benefit from a special RRSP contribution on retirement allowances of $2000 for each year of employment before 1996 as well as an additional $1500 for every year employed before 1989. Many government pensioners have very little room to contribute to their RRSP due to pension adjustments, therefore if you can, delay the payment until retirement to take advantage of these rules to save thousands of dollars in taxes!
Spread the payment to a new calendar year: If you have reached the decision that you are going to be hanging up your hat in a given year, look to retire at the beginning of another fiscal year. If you were to receive the severance payment in your last year of work where you are in many cases making the most money, the amount paid out to you will be added to your annual income and will be taxed based on the corresponding tax rate. This will generally push you into the highest tax brackets, which consequently lowers the amount of net severance received. You can request to retire and receive the amount in the year after your last full working year, this way the severance pay will be taxed in a year where in most cases your income will have dropped, thus lowering the tax payable on the amount.
Split up the amount to lower the tax burden: As mentioned above, the amount paid out can have a large impact on the taxes you pay in a given year. The ultimate goal is to reduce these taxes as much as possible. Another way of doing so is by splitting the amount into two payments, hence lowering your effective tax rate on the sum paid out to you. The government has allowed their employees to cash out a part of their severance (a round number of weeks) based on their current pay rate with the remainder payable upon retirement or termination of employment at their exit pay rate. This way gives you more flexibility if you had the intention to use some of the funds for a current purpose while also splitting up the amount received into different fiscal years.
Boost your Pension by Buying Back Years of Service: If you have taken a maternity leave, sabbatical or any other qualifying leave of absence you may want to think of buying back these pensionable years to increase your future pension income. The federal government has confirmed that employees who are eligible to buy-back pensionable periods will be able to use their severance payout for this purpose. By doing so, you will also be able to avoid taxations at source on the amount used to buyback pension by completing the CRA tax waiver form. Whether you should do this depends on many factors; primarily the cost of buying back the pension must be lower than the incremental increase in the value of your future pension income. Usually it is worth taking into consideration if you expect to continue to work at the government and expect to have future salary increases. The defined benefit pension plans at the government take your highest earning years to calculate your pension which typically makes buying back pensionable years in your lower earning years a good idea.
Think you need the income now? Think again. Your severance amount is based on your pay rate at the time you opt to receive it. If you decide to cash out the entirety of the amount now yet you expect to continue to work at the government with the expectation of future salary increases, your severance pay out will be smaller now than it could have been if you waited until retirement. Some employees would rather take the amount in cash despite having room in their RRSP’s. You may want to consider leveraging your RRSP despite wanting the money right away. By rolling the money into your RRSP you have the ability of converting a portion into a RRIF which would then give you the flexibility of withdrawing certain amounts in each fiscal year to minimize the tax impact of the severance pay. If you have money left over after maximizing your RRSP, think of maximizing your TFSA. Although you will be taxed on the remainder of the amount, it can then grow sheltered from taxes in your TFSA. You will then have the flexibility of taking the amount out of your TFSA without future tax consequences to your income.
It is important to note that the situation is specific for every individual and many factors come into play in order to choose the optimal solution. To have a comprehensive tax and retirement strategy consult a financial planner to help you get the most out of your money, keeping more of that hard earned cash in your pocket where it belongs!