Help laid-off clients save on tax

For the first eight months of 2009, more than 300,000 Canadians received a pink slip. And some who lost their jobs also had to deal with large sums in severance, and the uncertainty of what to do with it.

Bruce Cumming, president of Cumming & Cumming Wealth Management in Oakville, Ont., confirms he saw a definite jump in the number of his clients who were offered packages amidst the recent economic downturn.

Before he considers any tax and investment planning for the severance money, he chooses to address the financial and emotional factors of sudden joblessness. And he suggests that clients – particularly those with less than a year’s worth of emergency funds – steer away from investing that money.

“People are under enough pressure to get a job. One of the mitigating factors can be the fact that you’re sitting on money market funds,” says Cumming. “If that money had been put into Canadian or U.S. equities and the $50,000 (of severance) were now down to $30,000 and you still didn’t have a job, and we had another debacle in the market, that would create inordinate pressure. But if the market takes off, you’re sitting in money market funds and you get a job, you can catch up later. Having cash helps deal with the emotional part of it.”

Those who got terminated later in the year may have the option to stagger their severance pay over the course of a few years. Arranging to receive the second half of the package in January could help to reduce the income tax burden of receiving a one-time lump sum.

But advisors should be careful when recommending payment deferrals, warns Ellen J. Bessner, a partner at Cassels Brock & Blackwell LLP, as this may be construed as giving legal advice in an area the advisor might not be licensed in; as a result the advisor could be legally liable for consequences of the packages.

Other risks of receiving the package in different tax years is that the employer may run into financial problems in the future and default on paying out the balance of severance payments.

Another concern is the employer may find “skeletons” in the ex-employee’s closet and decide to renege on the agreement, citing dismissal with cause, says Cumming.If it’s clear income isn’t an issue and that finding another job won’t be much of a struggle for your client, then he or she could employ severance money in tax planning that ranges from the simple to complex.

Straightforward solutions

The simplest way to reduce taxation on severance money is rolling it into an RRSP. Tina Tehranchian, a CFP and branch manager with Assante Wealth Management, says some of her younger clients have used their severance money to make catch-up contributions to their RRSPs.

Clients who’ve been with the same employer for a long time and have little to no RRSP contribution room may be eligible to use the 60J Retiring Allowance rollover. This provision allows them to shelter $2,000 for every year of service before and including 1995 with the former employer, plus another $1,500 for each year up to and including 1988 they were not vested in employer’s pension plan or deferred profit sharing plan (there is no eligibility for employment years after 1996). While the severance money will be taxed, they will get an offsetting deduction for the amount they rolled into an RRSP and their contribution room won’t be affected.

Alternatively, if the client belonged to an employer pension plan or deferred profit pension plan, there may be opportunity to restore some RRSP contribution room that was previously used up by contributions into a registered pension plan or deferred profit sharing plan.

A pension adjustment reversal (PAR) creates RRSP room for clients who have ceased membership in a RPP or DPSP after 1997 and taken a commuted (lump sum) amount of their pension out of the plan.

PAR is calculated by adding up all the pension adjustments (PAs) and past service pension adjustments (PSPAs) reported on the T4 slip after 1989. Subtract this total from the commuted pension plan amount that relates to post 1989 years of service. If the amount is positive, (the sum of PA and PSPA exceed the commuted specified pension amount) this is the amount of contribution room that will be restored.

Clients with severance payouts have also invested the money in a tax-free savings account (TFSA), Tehranchian says. While putting money into a TFSA will not render immediate tax breaks, it will have definite benefits when they draw money from it during retirement. Funds drawn from a TFSA aren’t considered income. This is particularly important during retirement when government benefits such as OAS and GIS can be subject to claw-back if income exceeds a defined threshold amount – the income threshold amount for government benefits purposes for 2009 is $66,335.

Complex possibilities

For older individuals who received large severance payments and for whom tax planning is a more immediate concern, there are some advanced strategies available.

Flow through shares offer tax breaks at high risks. These are shares issued by Canadian companies in the energy and mining sectors that don’t have available capital to fund their upfront exploration costs. In order to raise money they sell shares. They don’t have any revenue for which they can apply for government tax deductions, so they “flow through” the deduction to their investors.

Consequently, investors enjoy an immediate tax deduction of 120% to 125% in Ontario – a combination of federal and provincial tax credits and deductions – on the amount contributed in the year of investment (the amount varies from province to province). For example, if a client invests $10,000, he or she will get a deduction of approximately $12,500. And if the investor is in the top tax bracket, “north of $130,000,” that should translate to approximately $6,000 in tax savings, explains Cumming. He points out with the tax savings the investor should break even if he or she gets $4,000 back from the investment.

These types of shares produce capital gains income regardless of whether they’re sold for more than or less than the original purchase amount. As the cost base of flow-through shares is typically zero, its sales price is the capital gain income that’s taxed. In light of the risks associated with flow-through funds, they are more appropriate for clients in the top marginal tax bracket. Since investors are required to hold the shares for a minimum of two years, they’re best suited for investors who do not need liquidity.

Despite the attractive tax benefits, clients must consider the investment quality of the product. Given that they can lose all their money, they should ultimately question whether the tax benefit is balanced with the investment return.

For those who neither have incomes exceeding $130,000, nor the stomach for higher risks, Tehranchian suggests corporate class funds. She points out that some companies have capital yield funds that invest in short-term bonds and instruments that offer a better rate than GICs.

Corporate class funds are a family of funds housed within a corporate structure that allow for switching between funds without triggering capital gains. It’s only when investors sell out of the structure that they’re in a deemed disposition of property. The investment also offers tax-efficient income, as it is treated as capital gains income.

However, these investments are exposed to interest rate fluctuations and would be better suited for investors who don’t need the money within two years.

During the early 1990s, corporate class funds often included higher fees. But over the years, the fee difference between corporate funds and the traditional group of funds has leveled off and at some companies there’s no difference in fees between the two fund groups.

When choosing corporate class funds, picking a fund company that offers a broader variety of asset classes within the corporate structure may offer better rebalancing opportunities.

If guaranteeing the principal investment is a priority and the client would like to access funds later in life, probably during retirement, Tehranchian adds a universal life policy may be a wiser choice over a vanilla GIC outside of a tax shelter account.Accordingly, if the individual wants the security of a GIC, purchasing it through a universal life may garner a higher return because the earnings while inside the policy are not taxed, leaving the interest income to compound.

A GIC outside of a tax shelter would need to provide a higher rate in order to offer similar returns as a GIC with a lower guaranteed rate growing inside a tax-sheltered universal life.

Inside the tax shelter of a universal life, a GIC with a guaranteed rate of 4.25, which is a combination of the 3% minimum gurantee in the first year and a 1.25% bonus that starts in second year, and add to the effect of compounding – a person would need a GIC with a guaranteed rate of 8% in a taxable account to get an equivalent return on a GIC inside a universal life policy, something impossible to find, explains Tehranchian.

Tehranchian notes that investments in a universal life are long term. Once money has been in the policy for an extended period, approximately 10 years, it can be gradually withdrawn to supplement retirement income. “The first series of income payments from the policy would be tax-free, coming as it were from the adjusted cost base (cost of insurance that has been paid). Once the adjusted cost base has been depleted, the payments would be drawn from the taxable growth portion. It is the later payments of investment growth that offer the advantage of tax deferral.”