Maximizing the opportunity from a severance
CPA, then CA, CFP
Maximizing the opportunity from a severance
Gene Rheaume, CPA, CA, CFP
This article will be featured in the December, 2011 issue of “The Bottom Line”
There are really two types of people who need help with financial transition planning. The happy majority of these cases can be classified as ‘windfall’ clients who have lottery winnings, stock option gains or inheritances. Those who are there because they’ve lost their job don’t feel quite as fortunate.
People who have become unemployed are often very concerned about this change in their future finances. Employers planning to implement layoffs can maximize the value to former employees by showing some flexibility and being proactive when dealing with their severance arrangements. Former employees receiving a package should consider several items to maximize the benefits from this transition.
A comprehensive analysis will help most people realize they have more time than they first thought to transition to new opportunities and this means they can make better long run decisions about which new opportunities to pursue.
An accountant should start with a review of the client’s overall net worth, budget requirements, family issues and future income prospects. In the short run, most people’s initial inclination is to worry about their cash flow and how long it will sustain their current lifestyle. This is the client’s ‘comfort zone”. The goal is to make this period as long as possible. Maximizing the after tax liquidity from all available sources and reducing the net outflows is the objective.
Looking at the individual’s net worth helps identify which sources of liquidity are available and in which order they should be accessed. Liquidity can take many forms; it can be money in non-registered accounts, money in RRSPs, unused credit or untapped value in residences. In many cases, clients should apply for increases in their lines of credit, especially if they are in a position where their employer has offered them a salary continuance option.
In many cases people’s first instinct is to pay off any high interest loans with their lump sum, assuming that reducing expensive debt will save them cash flow. Often paying off too much debt initially will shorten the ‘comfort zone’ compared to making minimum payments and keeping a larger pool of resources available to service all budget requirements.
Everyone agrees budgeting is prudent but many have never tried it or haven’t stuck with it. More people are willing to work on a budget when facing a job loss. Getting a good idea of where the money has been going is easier now when debit cards are used so frequently and credit cards with reward points encourage many to use their cards for almost everything.
In many situations, it helps to start with a worst case scenario to assess how long the comfort zone would be. This normally includes calculating some income from Employment Insurance (EI). Many people are unaware of how long it takes to start receiving EI. The total value of severance, vacation pay and any other subsequent payments are all considered as though the person is still at work regardless of whether it is paid in a lump sum or salary or deferred over different tax years. On top of this, there is a standard additional waiting period of another two weeks.
Understanding the prospects for new income is essential for tax planning. If taxable income is already high in the layoff year, and likely income next year is lower, then splitting the severance over two calendar years might make sense. Most employers are usually willing to do this. It’s a minor expense for them to issue an additional T-slip for the following year. It’s also an interest free loan for them. If a client’s earning potential for the next year is high and the income can be billed through a corporation then there could be very large benefits to the deferral into the next tax year. However, an employee should first consider whether the payment is secure before getting too excited about the tax savings.
If an employee has been a member of a defined benefit pension plan this can have a big impact on their planning. On termination an employee may be offered the option to transfer the commuted value of their pension entitlement out of the company pension plan. Normally most or all of this will go directly to a locked-in RRSP, however, there is often a portion that exceeds tax limits that has to be taken as cash. The decision to take the commuted value versus stay in the pension plan is a very difficult one that may require the advice of a professional financial planner.
If the employee elects to take the commuted value and a portion is taxable this needs to be factored into any tax and cash flow planning. In some, less frequent cases, the withdrawal from the pension plan may also re-instate lost RRSP room through the Pension Adjustment Reversal (PAR) calculation.
RRSP plans often play a significant role in planning for a buyout. There is a special RRSP entitlement under Section 60(j) of the Income Tax Act for employees with long service. For each year of employment before 1996, the basic entitlement is calculated at $2,000 per year. In addition, a further $1,500 is also available for each year before 1989 that the employee wasn’t vested in the company pension or deferred profit sharing plan. If the employee has got service with a previous employer that is considered pensionable, then these years can also be included in the basic entitlement.
It can be one of the few times in life when a person gets a break under tax laws, because he or she only needs one actual day in a calendar year for that year to qualify for the calculation. The employee will fill out a TD2 form which indicates the intended RRSP account that the funds are to go to. This is kept by the employer in their files but doesn’t need the advance blessing of Canada Revenue Agency. Unfortunately, unlike normal RRSP room, the transfer using this special provision cannot be made to a spousal RRSP. Because this is a special one-time limit that will never be available in the future, it almost always should be used, even where cash flow is a concern and the money may need to be withdrawn later.
Many clients are able to put part of their severance payment into RRSPs using their unused regular RRSP room. Most employers are willing to make a direct transfer provided there is proof of the employee’s available room, such as the previous year’s Notice of Assessment. This is a good opportunity to consider making a contribution to a spousal RRSP. Many individuals also ask for a direct transfer to their spouse’s account to use their spouse’s RRSP room. This isn’t permissible as an employer is only permitted to waive tax withholdings on payments that reduce the employee’s taxes. If the spouse has lower taxable income it might not be a good expenditure in any case.
An employee with concerns about cash flow can still benefit from making RRSP contributions, even if prospects for new income are not rosy in the near future. There may be a net gain in tax rates from using an RRSP to save tax in a high-income year followed by cashing in the funds in a lower tax bracket the following year. A good way to preserve cash in the short run is to withdraw from RRSPs in amounts under $5,000 at a time as the withholding rate is only ten per cent. This may create a larger tax bill the following year but by then the employee will likely be in a better position to deal with it. If the individual is planning to make a career change and intends to return to school they should consider borrowing money from their RRSP using a Lifelong Learning Program withdrawal.
There are a few points about severance that often surprise recipients. It is not considered as earned income and doesn’t impact on future RRSP room. The balance of the lump sum not directed to an RRSP will have a flat withholding tax rate of 30 per cent applied to it on amounts of $15,000 and over. The rates are 10 per cent on payments less than $5,000 and 20 per cent on the rest. In many cases this withholding rate may be relatively low compared to the marginal tax rate and sets up a potential tax liability on filing the tax return.
Most employees are accustomed to relying on their employers to withhold the correct amount of tax and are shocked to learn they will still owe tax, especially when they’ve made large RRSP contributions. The issue is the amount of tax withheld and it often can have a large impact on cash flow planning for the subsequent tax year. On a positive note, severance is not considered as insurable for EI and CPP, so there are no withholdings for these items even when a payment is deferred into a new tax year.
Other financial planning issues affecting people in this situation include replacing group benefit coverage. Private benefit plans can be purchased and it helps to work with an independent benefits consulting firm to find the best fit. If the former employer’s group plan offers a ‘follow me’ type of continuing coverage it is often wise to opt in before the deadline because there may be unrealized insurability issues that arise when being underwritten a new insurer.
When facing a difficult situation it’s important to remember that change creates opportunity. Facing a severance with the right approach will help to maximize that opportunity.
Gene Rheaume, CA, CFP is the President of Capital Transitions Inc, a fee for service firm offering objective counsel to clients facing financial transition decisions. Over the last 23 years, Gene has provided one-on-one financial guidance to over 7,000 former employees working with more than 150 employers. For more information, visit www.capitaltransitions.com or call (613)-236-4500 ex. 240.