Avoid Financial Pitfalls by Finding Your Blind Spots
Here’s the real-life situation:
- Experienced professional at a large company was laid off due to outsourcing
- He received a severance package, a pro-rated bonus, and stock options
- He had to make several decisions on his pension plans, Group RRSPs, Savings Plans, as well benefits (timing of payout, taxation, retaining benefits/insurance)
- He wanted to understand how best to plan his taxes for this year and the next
- He would be starting a new job shortly
Here are the 9 things you should consider:
1. Severance Pay
Your severance pay is considered ‘taxable income’, just the same as your salary, vacation, and bonus pay. Often times (but not always) your employer will withhold 15-30% of the total amount as income tax. Depending on your situation, if you have room available in your RRSP contribution and your company has a pension plan, you may benefit form requesting that your ex-employer make a source deduction and maximize the contribution to your pension plan. Since the way pension contributions affect your RRSP room, you may be able to get access to available room without waiting until the next tax filing by doing it this way. When you file your tax return, you will either get a refund or be assessed additional taxes.
2. Employment Insurance (EI) Benefits
When you receive a severance package, Service Canada will generally count that as an advanced payment of regular income. Depending on the amount, they will count it for x-number of weeks worth of income, and until that time period is over, you will not be eligible for benefits. It’s important for you to call or visit a Service Canada Centre to make sure you do receive the EI benefits you are entitled to. (The waiting period is approximately a week, so you can move on it pretty quickly, especially if you don’t receive severance pay.)
Is your plan a ‘Defined Contribution’ or a ‘Defined Benefit’ pension?
If it’s a ‘Defined Contribution’ plan, a pension transfer will not be taxed. It will simply be transferred into a ‘Locked-In RRSP’ (called LRSP if the plan is under Federal Legislation; LIRA if it’s under Provincial Legislation). Rules differ from province to province but generally speaking these are accounts that are intended to ensure that you can’t access your funds until retirement (typically Age 55+) – same as pensions. Your current provider will offer you an option to open an independent account with them and transfer the funds. Or, you may transfer it to almost any other investment provider in Canada.
In case that you have a ‘Defined Benefit’ (DB) plan, things get a bit more complicated. You will be offered an option to receive a commuted value (i.e. a lump sum equivalent to the value of the income stream the plan would have entitled you to), or to retain your position in the DB plan such that you receive an income stream at retirement. The option you choose should be based on numerous factors such as your age, financial position, family circumstances, and investment knowledge/sophistication. A portion of the commuted value may be taxable while the majority will likely be eligible to be transferred to their LRSP or LIRA. In this case, especially, it’s very important that you engage a financial planner with expertise in this area to provide you with a thorough analysis of your options, so that you can make an informed decision.
Some companies do not deduct taxes on bonuses paid out. If your company does this, be sure to set aside a portion of it to pay the tax-man or do some tax planning with.
5. Stock Options
Will you be forced to exercise the options immediately or do you have a period within which you can choose to exercise it? While you would have been taxed on the options when they were awarded to you, the moment you sell – you will have a capital loss or gain. Either way, this is another tax planning consideration/opportunity.
6. Savings Plans/Non-Registered Investment Accounts
If you had a savings plan at work, you either chose to keep it in cash, or invest into a mutual fund or shares in the company where you worked. If it’s cash, it’s an easy transfer into your bank account. However, if it’s a mutual fund or a stock, you need to be cognizant of whether there is a gain or loss. If there’s been a gain, and you choose to sell and cash it in, it may exacerbate your tax situation. Alternatively, you can choose transfer the investment in-kind i.e. without selling it. The assets can be placed in a self-directed account or with a financial planner/investment broker who is qualified to deal with these securities. By doing this, you retain control of the decision and timing of sale – leading to achieve a better tax outcome.
7. Group RRSPs
If you had a Group RRSP at work, the company where it is will offer to move it into an individual account with similar investment options. You may keep it there or move it to any other provider of your choice. There is no tax consequence for this transfer (although, there might be administration fees assessed).
8. Personal RRSPs
If you have RRSP contribution room, and you got paid several lump sums of money like severances and bonuses, this is often a simple and obvious short-term tax planning solution. Funding an account with the proceeds may help reduce your marginal (top) tax rate and result in significant savings.
Depending on the benefits at your new company, and the portability of benefits at your old company, it may be worthwhile to carry some of the coverage over. A key benefit is that you are already underwritten for the insurance. In some cases, you may also retain a significant portion of the group discount. The most important one to assess transfer options for is disability insurance, as it is the highest likelihood and often has the greatest financial impact on families – it’s also the one that is least portable. It can be valuable to retain some of the critical illness and life insurance benefits as well. In the process of making this decision, consulting a financial planner who can do an assessment of how much insurance you actually need will be invaluable to decision-making.
If you’d like more specific feedback based on your actual numbers, please feel free to contact me at firstname.lastname@example.org for a consult via video conference. Your situation might be complex enough to warrant professional analysis, especially if you still have a mortgage, car payments, and children; and need to ensure you can sustain your cash flow needs.