Strategies for Lowering Taxes on Severance Pay in the USA and Canada

Severance pay is often a welcome financial cushion during a difficult transition, but it can also be a taxable event, leading to a significant tax burden. Tax laws and strategies vary between the USA and Canada, so it's essential to understand how to reduce your tax liability on severance pay effectively.

Understanding Severance Pay in Canada

In Canada, employees in certain provinces can offset severance pay by making equivalent contributions to their Registered Retirement Savings Plan (RRSP). This can be done provided you have the room in your RRSP limits, and you can check your contribution room on your Notice of Assessment or by contacting the Canada Revenue Agency.

IRS Guidelines for Severance Pay in the USA

If your former employer is based in the USA and follows IRS guidelines, withholding taxes on severance pay can be a bit more complex. Severance pay is subject to a preset tax rate of 22 for amounts up to $1 million, after which the rate increases to 37. Any effort to change the withholding setup for this payment, like claiming exempt status, has become considerably more difficult.

If you attempt to claim exemption, you must fill out the appropriate paperwork and will still be required to pay the taxes in the future. As such, it's advisable to accept the 22% rate, which is significantly lower than the previous 35% rate before the Tax Cuts and Jobs Act of 2017. The act increased the national debt, but it's worth noting that a 37% rate for severance pay over $1 million is still on the higher side.

Tax Planning Strategies for Severance Pay

Several strategical approaches can help you manage the taxes on severance pay effectively. Here are some considerations:

1. Timed Severance Payments
Timing the severance pay to span over the current year and the next year can defer some tax liability until the next taxable year. This can be particularly useful if you expect your income to decrease in the following year.

2. Designated Reimbursements
Within a settlement agreement, you can designate some of the pay as a reimbursement of previously unreimbursed business expenses. This strategy can be especially beneficial if you have legitimate business expenses that you haven't yet been reimbursed for.

3. Medical and Property Reimbursements
Allocate some of the payment to cover untaxable medical expenses resulting from an injury on the job, or the replacement of lost personal property. This can further reduce your taxable income.

4. Post-Employment Consulting Contracts
A post-employment consulting contract can be structured to include payments that are subject to self-employment tax, but with deductible business expenses. This can include items like a new work computer for yourself or a home office.

5. Relocation to No-Income-Tax States
If you are leaving for a new job, consider moving to a state with no state income tax. This can significantly lower your overall tax liability.

Additionally, you can employ standard tax planning strategies for regular income, such as maximizing deductions, donating to charity, and other tax-advantaged moves.

Conclusion

Tackling the tax consequences of severance pay can be challenging, but with the right strategies and understanding of the laws, you can mitigate the impact. Whether you are in Canada or the USA, understanding the tax rules and employing effective planning can help you minimize the financial burden during a potentially difficult period.