Minimize Taxes on Severance Pay in Canada

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I’ve been given notice of an indefinite layoff at work and am wondering whether you can provide some information that will prove useful to a number of people in a similar situation.

What is the best way to minimize the tax when it comes to a severance package payment?

Because of my age and the number of years at work I’m eligible to retire with an unreduced pension. Can I get the severance package and retire at the same time? Is it doable?

I’m not planning on applying for CPP/OAS until after my 65th birthday (I’m 63 now); will my CPP/OAS payments suffer because of this? Can I continue to contribute towards them if I don’t work?

—Andrea

Tax on severance pay in Canada

Sorry to hear about your layoff, Andrea — unexpected job loss is stressful, both emotionally and financially. If you receive a large severance payment, the tax impact can be substantial. A common issue is receiving a lump-sum severance late in the calendar year, which can push what would be multiple years of income into a single tax year and push you into a higher tax bracket.

Employers structure severance in different ways: salary continuance (paying your regular salary for a period), a lump-sum payment, or spreading payments over multiple years. Where possible, it’s worth discussing timing and structure with your employer. An employment lawyer or experienced financial adviser can help you understand your entitlements and negotiate terms before you sign any agreement.

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Taxes on lump-sum severance pay in Canada

If you’re offered a lump-sum severance at year-end, ask whether the payment can be deferred to the following calendar year or spread over more than one year. That simple timing change can reduce the total tax you pay.

For example, a British Columbia resident earning $75,000 in salary might pay roughly $14,000 in income tax for the year. If they receive an additional $75,000 severance in the same tax year, their combined tax could rise to about $41,000. Splitting that $150,000 across two tax years could reduce the total tax to roughly $28,000 — a potential saving of around $13,000. Exact amounts depend on province, credits and deductions, but the principle is clear: spreading income can lower your marginal tax burden.

Consider RRSP contributions

One commonly used strategy to reduce tax on severance is to contribute to a registered retirement savings plan (RRSP). If you have significant unused RRSP contribution room, you may be able to direct some or all of your severance into an RRSP on a pre-tax basis. Employers can sometimes arrange a direct transfer of the severance into an RRSP.

If the employer pays you the severance in cash (with tax withheld) and you later contribute to your RRSP, you’ll temporarily have less after-tax cash available to make the contribution and will need to wait for any tax refund. For that reason, arranging a direct RRSP transfer from the employer can be preferable when possible.

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Long-service employees may also qualify for an eligible retiring allowance, which can create additional RRSP room beyond the standard annual limit. The Canada Revenue Agency outlines how the eligible portion of a retiring allowance is calculated; a summary of the eligible components is quoted below.

1) $2,000 for each year or part-year of service before 1996 in which you were employed by the employer.

2) An additional $1,500 for each year or part of year of service before 1989 in which you had earned no pension or DPSP (deferred profit sharing plan) benefit from employer contributions that either vested in you at the time of payment or that were previously paid to you.

Receiving severance and retiring

Because you qualify for an unreduced pension, you’ve likely been in your employer’s pension plan for many years. A severance payment is compensation for the loss of employment; your pension is a separate entitlement based on your plan membership and contributions. In many cases you can receive a severance and commence your pension around the same time, but the interaction depends on your plan’s rules and the terms of the severance.

One detail to consider: if your employer provides salary continuance (continuing to pay salary for a set period), you may continue to accumulate pension service and contributions during that period. That can affect your final pension amount or help you meet service or age thresholds for an unreduced pension if you’re close to qualifying.

What about CPP and OAS?

The Canada Pension Plan (CPP) and Old Age Security (OAS) work differently from employer pensions. CPP is contributory — the amount you and your employer (or you alone if self-employed) contribute during working years determines your CPP retirement benefit. There’s no option to make voluntary CPP contributions unless you have employment or self-employment income, so if you stop working you cannot continue contributing to CPP unless you earn income that requires CPP contributions.

OAS is a non-contributory, residency-based benefit paid from age 65 onward. Your entitlement depends on how long you’ve lived in Canada; long-term residents typically qualify for the maximum OAS. Be aware that high retirement income can trigger the OAS recovery tax (clawback), reducing or eliminating OAS benefits for high earners.

You mentioned planning to start CPP and OAS at 65. That’s a common choice, but if your health and finances allow, delaying CPP and OAS up to age 70 can significantly increase monthly benefits. Unlike many employer defined-benefit pensions, CPP and OAS payments are higher if you defer past 65 (up to age 70) and reduced if taken earlier. Consider your health, life expectancy, cash-flow needs, and other sources of retirement income when deciding when to start these benefits.

Good luck with your severance discussions and your transition into retirement — getting the timing and structure right can materially affect your taxes and long-term income.