If you’re reviewing a termination package that includes a ‘retiring allowance,’ it might sound like a perk tied to retirement. That makes sense, right? Not really.
Despite the name, a retirement allowance in Canada has nothing to do with retirement. In most employment law cases, it simply means money paid to an employee upon or after termination of employment in recognition of long service. It’s a tax term, not a legal entitlement, and it often leads to confusion when planning severance packages or reporting to the CRA. Let’s break down what it is – and what it isn’t.
What Is a Retiring Allowance?
A retiring allowance under the Income Tax Act is any payment made to an employee:
For loss of employment, or
In recognition of long service
but excluding payments that are otherwise employment income (like salary continuance, vacation pay, or bonuses).
It’s most commonly used for lump sum payments in a severance deal. But there’s no need for the employee to be near retirement. An employee terminated at age 35 after 10 years of service could receive a “retiring allowance.”
Why Does It Matter?
The retiring allowance category triggers specific tax rules – some of which can be beneficial:
RRSP Rollover Potential
Employees with pre-1996 service can transfer a portion of their retiring allowance directly into an RRSP without using up the RRSP contribution room. The formula is:
- $2,000 per year of service before 1996, plus
- $1,500 per year before 1989 if no pension was earned for those years.
This rollover can defer tax on part of the severance, but very few employees have long enough tenure to benefit from this anymore. If an employee started after 1995, the rollover benefit doesn’t apply.
Tax Withholding Rates:
CRA applies flat withholding rates to retiring allowances (e.g. 10% on the first $5,000), which might seem attractive. But this isn’t the final tax owed – just a temporary withholding. Many employees assume the lower tax deducted is the final amount, only to face a higher tax bill come April.
What’s the Risk?
The biggest issue is misunderstanding:
- Employees may wrongly assume a tax break they’re not eligible for, especially with the RRSP rollover.
- Employers may code severance as a retiring allowance when it should be treated as regular employment income.
- Payroll teams sometimes under-deduct, creating tax liabilities for the employee.
- Settlement negotiations can get messy if neither party understands what qualifies or how to structure payments properly.
If an employee pockets the funds and doesn’t contribute them to an RRSP, they’ll still be taxed on the full amount at their marginal tax rate when they file. If that rate is higher than 20% they’ll owe the difference to CRA. If not, they will get a refund.
So while less is withheld upfront, there’s no tax savings unless the employee defers the income via an RRSP contribution, which many simply aren’t in a position to do on termination.
Bottom Line
Who’s on the hook for mistakes? The CRA expects employers to classify and report these payments correctly. If an employer mislabels a payment or under-deducts tax, they can face penalties, interest and audits. Even if it was a payroll error, the business is on the hook — not just the employee.
If you’re drafting a termination package and you’re not 100% sure what qualifies as a retiring allowance, talk to your employment lawyer. The CRA rules are precise, and a small misstep can cause a big headache later. If you allocate to a retiring allowance, spell it out in your agreement. This helps with CRA compliance, payroll coding, and employee communication. If the agreement is vague, expect trouble at tax time — or worse, a CRA reassessment.
We help HR pros like you spot these nuances before they become problems. If you’re dealing with a severance situation, we can review and structure the package for tax efficiency and compliance. Let’s make sure you and your employees aren’t left guessing. Give us a call today!
