You’ve decided to retire or you have been let go from your job and have been offered a generous severance package. If you take the full payment, the entire amount will be taxable when you receive it. However, with some careful planning, you can reduce the immediate tax consequences.
Make Sure Its A “Retiring Allowance”
It is important to make sure that what you are receiving is a “retiring allowance” so that you are able to transfer the payment to your RRSP on a tax-deferred (rollover) basis.
A retiring allowance is an amount that you receive from your employer in recognition of long service or compensation for loss of employment. Other types of payment may also be considered part of the retiring allowance: Unused sick leave credits for example will be included as part of the retiring allowance provided they are paid on or after your termination.
On the other hand, pay in lieu of notice or unused vacation pay are not considered a retiring allowance.
Planning Options
- RRSP Rollover – If you were employed with the same employer prior to 1996, a portion of the retiring allowance can be transferred directly to your RRSP and will not affect your RRSP limit.
- RRSP Contribution – If you are unable to use the RRSP rollover provision but have RRSP contribution room, you can make an RRSP contribution.
- Severance Installments – If your employer is going to pay you over a period of years (normally two), you can reduce the tax bill by splitting the severance payment over different tax years.
Estate Planning Considerations
If a person dies before receiving the retiring allowance the amount is taxable. However, if the amount is significant, your executor may file a separate “right or thing” tax return and reduce income tax.
To Contribute or Not To Contribute That is The Question?
Every year the big debate is whether you should contribute to your RRSP now or wait. There are a number of variable to consider: Will you be in a higher or lower tax bracket in retirement? What tax brackets will your spouse be in? How much contribution room is available? More importantly, it’s important to look at your overall picture and determine where RRSP’s fit into your overall financial plan.
The Basic Concept
An RRSP is a tax-deferral account: You deduct contributions from taxable income and withdrawals are added to taxable income. If you expect to be in a lower tax bracket in retirement, then you can defer some tax and realize an overall net savings. If you expect to be in the same tax bracket in retirement, then you have a deferral of tax which allows more of your money to grow (a benefit).
On the other hand, if you income will be higher in retirement, then the RRSP becomes an issue.
Some Simple Tips
- Have plan – Consider what you expect your retirement to look like and work back from there. The planning process should give you an idea of whether you will be in a higher or lower tax bracket.
- If you’re in a low tax bracket – You may not save much in tax by contributing now. However, if you will be in a higher bracket in the near future, you can still make the contribution but don’t take the deduction until later.
- If you’re in a high bracket but spouse in a low bracket – Make a spousal contribution. You’ll take the deduction in a high bracket and your spouse will withdraw at a low rate (be aware of the spousal attribution rules).
- Contribute early– The sooner you make the contribution and make your investments, the longer your money will be working for you.
Finally, if you get a tax refund, do something wise with it: Put it against your mortgage or pay off other debt and invest the difference.
The chief end for all small business owners is to make as much money as they can and build a business that they can one day get out from under and retire happy, healthy and at a minimum financial stable. RRSP’s and Canada’s new Tax-Free Savings Account (TFSA) are two of the tools that are used to build wealth now to plan for the future.
