How Severance Pay Is Taxed in Canada (and How to Reduce the Tax Hit)

How Severance Is Taxed

Severance pay in Canada is classified as employment income — it’s fully taxable in the year you receive it. There’s no special capital gains treatment, no reduced inclusion rate, and no tax-free threshold.

When your employer pays severance as a lump sum, they must withhold tax at flat rates (instead of your regular payroll rate):

Lump-sum amount	Federal withholding rate
Up to $5,000	10%
$5,001 – $15,000	20%
Over $15,000	30%

Quebec: Flat 14% provincial withholding on all amounts, in addition to federal.

Important: These withholding rates are not your actual tax rate. If you receive a $60,000 severance and have other income during the year, your true marginal rate could be 40%+ — meaning you may owe a significant balance at tax time. Conversely, if it’s your only income, the withholding may be too high and you’ll get a refund.

Severance vs Retiring Allowance

The distinction matters for tax planning:

• Severance pay: Compensation for loss of employment. Fully taxable, no special RRSP transfer rules.
• Retiring allowance: Broader term that includes severance, but also payments in recognition of long service. Has a special RRSP transfer provision for pre-1996 service.

The RRSP transfer opportunity

If part of your payment qualifies as a retiring allowance for service before 1996, you can transfer it directly to your RRSP without using your regular RRSP contribution room:

Service period	Eligible RRSP transfer
Pre-1996 years with employer pension	$2,000 per year of service
Pre-1996 years without employer pension	$3,500 per year of service
Post-1995 service	$0 — no special transfer

Example: An employee with 10 years of pre-1996 service (no pension) can transfer up to $35,000 directly to their RRSP, tax-deferred, in addition to their regular RRSP room.

Five Strategies to Reduce the Tax

1. Contribute to your RRSP

The most effective strategy for most people. If you have RRSP contribution room, contribute some or all of the severance. The RRSP deduction offsets the severance income, potentially keeping you in a lower tax bracket.

Example: You receive $60,000 severance and have $40,000 of RRSP room. Contributing $40,000 reduces your taxable severance to $20,000. At a 30% marginal rate, that’s $12,000 in tax savings.

Ask your employer to transfer the RRSP portion directly — this avoids withholding tax entirely on the transferred amount.

2. Negotiate payment over two tax years

If your termination happens late in the year, ask whether the employer can split the payment: a portion in December, the rest in January. This spreads the income across two tax years, potentially keeping both years in lower brackets.

3. Deduct legal fees

If you hired a lawyer to negotiate your severance or sue for wrongful dismissal, those legal fees are deductible against the severance income. You can claim them in the year paid, and carry forward unused deductions for up to seven years.

4. Use the lump-sum tax treatment

If you received a lump-sum retroactive payment that includes amounts for prior years, you may be eligible for a special tax calculation (CRA Form T1198). This calculates tax as if the payment had been received in the year it related to — useful if you were in a lower bracket in prior years.

5. Time your other deductions

In the year you receive severance, consider maximizing other deductions: childcare expenses, moving expenses (if you relocated for a new job), union dues, or professional fees. Stacking deductions in a high-income year produces bigger tax savings.

Impact on EI Benefits

Receiving severance can affect when your Employment Insurance (EI) benefits begin:

• Severance that is paid as salary continuance (regular paycheques) delays EI — benefits start only after the continuance ends
• Lump-sum severance does not delay EI in most cases, provided the payment is a genuine severance (not pay in lieu of notice)
• Pay in lieu of notice allocates the payment over the notice period, delaying EI by that duration

Check with Service Canada about your specific situation, as the treatment varies based on how the severance is structured in your Record of Employment (ROE).

Worked Example

Sarah is terminated after 15 years of service (all post-2000). She receives $60,000 severance as a lump sum. Her regular salary was $85,000 and she worked 8 months before termination.

	Without RRSP strategy	With RRSP strategy
Employment income (8 months)	$56,667	$56,667
Severance	$60,000	$60,000
RRSP deduction	$0	−$35,000
Taxable income	$116,667	$81,667
Approximate federal + provincial tax (Ontario)	~$28,500	~$17,200
Tax savings	—	~$11,300

By contributing $35,000 of her severance to her RRSP, Sarah saves approximately $11,300 in tax for the year.

The Bottom Line

• Severance is fully taxable employment income — withholding rates (10-30%) may not reflect your actual tax rate
• Pre-1996 service may qualify for special RRSP transfers ($2,000-$3,500 per year) above your regular room
• The biggest lever is RRSP contribution — ask for a direct transfer to avoid withholding
• Legal fees to negotiate severance are deductible
• Severance structure affects EI eligibility — lump sums are generally better than salary continuance for EI timing

Use the severance tax calculator to estimate your after-tax severance, and the RRSP calculator to model the tax savings from contributing your severance to an RRSP.