Evaluate your financial situation
Receiving severance pay means that you are leaving your job. Therefore, whether for retirement or a period of unemployment, you must be able to lessen the blow of any unforeseen circumstances for an indefinite amount of time. That’s why it is recommended you start by replenishing your contingency funds, if necessary.
Once you have set aside enough money for essential expenses, get an overall picture of your financial situation. Determine your assets and debts so you can plan better. Take time to think about your future. Do you think you’ll be able to find a new job quickly? Would you like to use the money to retire sooner or go back to school? Or do you have projects you’d like to get started on now? Answering these questions will help you decide how best to use your severance pay.
What type of investment is right for you?
Before investing, determine your investor profile. Doing this will help you choose where and how to use your severance pay for an optimal return.
If you’re approaching retirement, you will undoubtedly prefer more secure investments. On the other hand, someone at the start of their career who has just entered the workforce has more time to absorb losses in the event of disappointing returns. However, a young investor should also limit risks if they have short-term goals, such as buying a home. In every case, your plan must be personalized to avoid bad investments and maximize the chances of achieving your goals.
Experts recommend that you avoid putting all your eggs in one basket—a well-diversified portfolio helps reduce risks. For example, mutual funds may include a certain percentage of shares (which are more volatile) and bonds (which guarantee capital). You can even diversify with business shares from different countries or industries. In the event of market fluctuation, the impact on your portfolio will be less significant.
Consulting with an advisor to build your portfolio is ideal. They can help you avoid the most common errors made in financial planning.
How to reduce the tax payable
It’s inevitable: You have to pay taxes on your severance pay. Don’t be surprised if the bill is steep, especially if the severance raises your income to a higher tax bracket. Thankfully, there are many strategies you can use to help reduce this amount. Here are three examples to limit the effect of taxes on your severance (note that the information presented below is specific to Quebec and may not apply in other parts of the country):
1. Contribute to your Registered Retirement Savings Plan (RRSP)
RRSP contributions are deductible from your income, allowing you to enjoy significant savings on your taxes.
You can use your unused RRSP contribution room as a place to invest your severance pay. However, for long-term employees, there is a strategy that has zero impact on your unused amount. These workers have the right to transfer $2,000 to their RRSP per year worked (complete or partial) before 1996, as well as an additional $1,500 per year worked before 1989.
2. Contribute to your spouse’s RRSP
Contributing to your spouse’s RRSP is also a good strategy to invest your money, tax-free. You must, however, invest directly into a specific account to take advantage of the deduction. If you give the money to your spouse to contribute to their RRSP, you will not benefit from the tax deduction.
3. Contribute to a Tax-Free Savings Account (TFSA)
TFSA contributions are not tax deductible. On the other hand, returns are not taxable. That’s beneficial!
Other ideas for using your severance pay
Here are some additional suggestions for using your severance pay wisely.
If you have debts, consider using your severance to repay them. Start with debts that have the highest interest rate, such as credit cards.
Lifelong Learning Plan (LLP)
If you envision yourself going back to school, you could invest your severance pay in your RRSP. Then, the LLP allows you to withdraw up to $20,000 tax-free to finance your goal.
Do you have the means to donate part of your severance pay to a charitable organization? The receipt will help you save on taxes.
Registered Educations Savings Plan (RESP)
Are you considering investing money in your children’s or grandchildren’s education? With the RESP, they could benefit from government subsidies.
When used properly, your severance pay can help keep you and your loved ones in a stable financial situation. It may even improve it, despite the termination of your employment. In this respect, your financial advisor can support your goals by helping you come up with different strategies that will really pay off.