How is a lump-sum severance taxed?
When you lose your job and receive severance, it may be paid as a lump sum payment. It is generally a certain number of weeks of salary that increases based on factors like length of service, age, and seniority. Other factors can play a role, though.
When you receive a lump sum payment, the withholding tax is generally only 30%. The problem is that regardless of the withholding tax on a lump sum severance payment or any other source of income, when you file your tax return, the appropriate tax rate is determined.
If you receive a large severance, or have a high income to begin with, the tax owing on the payment could be an additional 20% or more.
Related reading: How to avoid tax on severance pay
How is salary continuance taxed?
When you lose your job, you may continue to be paid your regular salary for a certain period of time. This is called salary continuance.
The payroll withholding tax is the same as if you continued to be paid a salary. The result is that your tax withholding should be more or less in line with what your tax owing will be on your tax return, barring other income sources, tax deductions, or tax credits.
How does a corporation save tax?
Corporations can help defer and save tax, Geoffrey, but it depends on the circumstances. The best tax use case for a corporation is to earn active business income. If you run a business and earn profit through a corporation that you leave in the corporation and do not withdraw, it can be subject to a low rate of tax.
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Depending on the province or territory, it can be as low as 9 to 12%. There is more tax payable when you withdraw the money and use it personally, but a corporation is definitely a great tax deferral tool.
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The problem with the severance is that it is employment income. If you have it paid into a corporation or you transfer the payment into a corporation, that does not magically turn T4 employment income into corporate active business income. As a result, a corporation will not help you save tax on a severance.
Does putting money into a corporation to invest save tax?
The tax rate on investment income earned in a corporation is similar to the top tax rate in most provinces and territories. As a result, earning investment income in a corporation tends to result in comparable or even more tax than earning it personally, Geoffrey.
So, why do people use investment holding companies? The reason is the aforementioned small business tax rate of 9 to 12%. If you earn business income and can leave it in a corporation to invest, you may be able to invest roughly 90 cents on the dollar of your corporate profit.
Business owners often do so using a separate investment holding company, where they can transfer money out of their active business. However, putting personal savings into a corporation to invest will not generally save you tax.
How can you save tax on a severance?
If you want to save tax on a severance, there are two easy ways, Geoffrey.
The first is to contribute to your registered retirement savings plan (RRSP). You may even have the opportunity to have your employer transfer some or all of your severance directly into your RRSP with no withholding tax. But remember, this is like getting your tax refund up front. You will not also get a tax refund when you file your tax return.
The second opportunity is to defer the severance to a future year. Especially if it is later in the calendar year, your employer may be open to deferring the payment to January to push the incremental tax back one year. Some employers will pay a severance over multiple years, but this is less common.
