Is my severance tax deductible?
Being paid severance is bad enough since it means you have lost your job. Being taxed on it with perhaps no prospects of other employment in the near term is even worse. Are there ways to save tax on the severance you received? Are the expenses of looking for a job tax deductible? What tax deductions are available to ensure you minimize your tax?
My usual disclaimers apply to this non-exhaustive overview of both Canadian and U.S. law. Please do seek qualified accounting advice on this matter. The point of this post is to provide enough information for anyone who received severance or is looking for a job to flag possible tax deductions which they would otherwise miss and let their accountant make the appropriate deductions if available (as a definitional term, I use the term “severance” in its normal everyday sense and not as a legal term of art).
Income during your notice period continues to be taxed in the same manner as before your notice was given. However, certain taxpayers may have relief if they qualify under the definition of a “retiring allowance“. In plain English, a portion of your severance can be deferred by contributing to your RRSP without the need for income tax, EI or CPP deductions being taken. In other words, before tax income can be used to contribute to your RRSP. The amount eligible is:
- $2,000 for each year or part year of service with an employee before 1996; PLUS
- $1,500 for each year before 1989 for which no employer contributions to a pension plan or deferred plan have vested in the employee (in plain English, the employee worked for an employer without a pension plan).
The retiring allowance cannot exceed the severance amount. If you are paid a lump sum settlement, you are also not eligible for a retirement allowance. Please note the retiring allowance is also not earned income for the purposes of RRSP contributions and it cannot be included to increase RSP contribution room for the subsequent year. For example, assume you made $40,000 in 2009 before you were let go and contributed $4,000 to your RSP as a retiring allowance. Your contribution room for 2010 is $40,000 x 18% and NOT $44,000 x 18%.
The retiring allowance, obviously, favors older workers with long service records with an employer. Most younger employees or employees in industries that experience great mobility (for example, IT) will not qualify for the retiring allowance.
Thus, what other tax deductions are available to a terminated employee?
- Legal expenses: Legal fees paid to establish a right to collect or establish a right to employment income are deductible.
- Counselling services for re-employment: Career transition fees are non taxable benefits. Shrewd employees would ask for this benefit as part of the severance package to maximize tax advantages as well as the obvious benefits to one’s career. If you require general mental health counselling, the fees are also non-taxable and a similar strategy should be applied in negotiation a package.
- Professional Dues: If you required to pay professional dues to maintain professional status set out by law (lawyers, doctors, engineers, architects) and your employer previously paid these dues, the dues are tax deductible if you now pay these yourself.
One may also be eligible for the tuition fee credit if you return to school.
Just a note if you were issued employee stock options, as Michael James pointed out, the tax law on employee stock options can often be punitive in Canada. If you hold a lot of options, best to seek some tax advice.
Many eligible deductions which may be applicable in job loss situations are governed under the IRS’ miscellanous deductions. Generally, income made as part of severance continue to be taxed in the same manner as before notice was provided. The following are some examples of deductions available normally outside of job loss but, contextually, become more important when unemployed:
- Professional due: the general test is whether the dues are required to carry out your job
- Job hunting expenses: Provided it is in the same field (even if not successful)
- Resumes: costs associated with preparing and sending out resumes (postage, paper, photocopy) if you are looking for a new job in your current field
- career counselling
The above deductions must be reduced by 2% of your adjusted gross income if you qualify.
Travel costs to look for work or attend an interview are generally tax deductible under “travel, car, entertainment, gift and car expenses.”
Since the health care proposal is not law, health insurance premiums may also be eligible for a tax deduction if your employer once paid for these benefits and now you pay the premiums.
Educational costs can also be subject to credits and deductions.
As a general comment, there is nothing stopping an individual from earning both employment and business income in the same year. Thus, if a job transition stategy is to cease to be an employee and to become a business owner instead, the taxpayer may be eligible for a wider range of business deductions not typically available to employees and those deductions can be applied against business income earned (as you can see, the tax regime for employees is, relatively speaking, not friendly).
The above are some general ideas to help one who has been or is unemployed save some taxes. Any issues about the eligbility of a deduction or the amont of deduction one can take should be referred to a qualified accountant. Good luck.