When you leave your employment, whether voluntarily or involuntarily, there are financial issues that you have to be aware of and one of them is your retiring allowance.
If you want to know if you’re eligible to receive a retiring allowance, you must first understand what it is and how it works so you can make informed decisions based on your financial circumstances.
What is a Retiring Allowance?
In Canada, a retiring allowance refers to the amount paid to an employee upon the termination of employment due to retirement, resignation, or dismissal. If your circumstance falls into any of these categories, you’re likely eligible to receive a retiring allowance.
While the terms “retiring allowance” and “severance package” are sometimes used interchangeably, they are, technically, not the same. A retiring allowance is just one component of a severance package, which may include other benefits and incentives.
It’s important to point out the distinction because retirement allowance payments may qualify for special tax treatment under the Canadian Income Tax Act.
You will receive a retiring allowance:
- On or after your retirement from an office or employment in recognition of your long service to the company or organization; or
- Upon loss of office or employment, as a result of your resignation or dismissal
What payments qualify as part of a retiring allowance?
The amount of retiring allowance you will receive will be based on the length of service and the position in the company you work for.
Payments that qualify as part of the retiring allowance are:
- Cash equivalent for unused sick leave credits
- Amount that a person receives when the office or employment is terminated. In the case of wrongful dismissal, it may include payment of damages in accordance with a court order or judgment of a competent tribunal.
What payments do not qualify as part of a retiring allowance?
Payments that are not included in the retiring allowance are:
- Unused accumulated vacation leave credits
- Pension benefit, a superannuation fund, or income from a retirement compensation arrangement.
- Salaries, wages, overtime pay, and bonuses.
- Death benefits (upon the death of the employee)
- A benefit derived from counselling services provided by the employer in relation to retirement or re-employment.
- Legal fees
- A payment in lieu of termination notice.
- Damages for violations of an employee’s human rights awarded to the employee in accordance with human rights legislation.
Is retiring allowance taxable?
The short answer is yes. Since a retiring allowance is treated as a lump-sum payment, you have to deduct income tax from it. However, you may be able to shelter your retiring allowance from tax by transferring all or part of it to a registered pension plan (RPP) or a registered retirement savings plan (RRSP).
This means that there is a portion of your retiring allowance that is eligible for transfer to an RRSP, which then becomes exempt from tax.
But keep in mind that there is a limit to the amount that you can transfer to the RRSP. Under Section 60(j.1) of the Income Tax Act, the eligible portion of your retiring allowance is limited to:
- The sum of $2,000 for each year of service (or part of the year) prior to 1996 that you worked for the company or employer.
This means that for every year of service up to and including 1995, you’re allowed to transfer $2,000 to an RRSP. Unfortunately, you can’t transfer to an RRSP from 1996 onwards.
How to compute the eligible retiring allowance
So, let’s say, you started working for the company in 1988 and retired in 2020. The eligible portion of your retiring allowance is $14,000 for the 7 years of service from 1988 up to 1995. That amount can be transferred directly to an RRSP and is sheltered from tax until you decide to take the money out of the plan.
But wait, there’s more.
So, in our example, the total portion of your retiring allowance eligible for transfer to an RRSP is $15,500 ($14,000 plus the additional $1,500 for 1 year of service prior to 1989).
Your employer will not withhold tax on the payment of the eligible retiring allowance when it is transferred to your RRSP.
Important things to remember about retiring allowance
- If your employment is terminated but you are re-employed by the same company, it may affect the status of payment of your retiring allowance.
- A retiring allowance is not considered an earned income. The transfer of the eligible portion has no effect on the deduction limit of your RRSP, Specified Pension Plan (SPP), or Pooled Registered Pension Plan (PRPP).
- The direct transfer of your retiring allowance to your RPP may require a pension adjustment which would affect the deduction limit of your RRSP.
- You must transfer your eligible portion of retiring allowance to your RRSP before you turn 72 years old. If you are more than 71 years at the end of the tax year, you will not be allowed to transfer any portion of a retiring allowance into your RRSP.
- You cannot transfer your retiring allowance to the RRSP of your spouse or your common-law partner.
- The non-eligible portion of your retiring allowance can only be transferred to your RRSP if you still have unused contribution room.
Financial Planning Considerations for Your Retiring Allowance
While the special tax rules on retiring allowances allow you to shelter a portion of that fund from tax, it doesn’t necessarily mean that you should transfer it to an RRSP straight away.
You may want to use your retiring allowance for more important needs like paying down debts or investing in a business. You may need the funds to venture into other things or simply use it as a buffer as you transition from employment to retirement.
In these challenging times, you need to have strong financial flexibility where your cash flow needs are met no matter the circumstances. Consult your advisor if you want to minimize the tax impact of your funds and to know what options you have to maximize the use of your retiring allowance.