An old friend was let go from her employment just before the summer. It came as a shock, even though the company warned staff about headcount concerns in the continuing sideways economy.
While her ego was bruised, her skill set remained intact and she had access to immediate outsourcing support. But with the summer ahead, she wondered how soon she would get back to work, assuming that the job market would be sluggish for the season.
Savings options for terminal pay
Meanwhile, she hadn’t even received her final paycheque. The company offered to have a portion of the terminal pay directed to her group RRSP, but needed her instructions soon. This only added to her stress.
She had three choices:
- To allocate a dollar to RRSP, meaning a full payroll dollar was invested immediately.
- She could invest in her individual RRSP using after-tax funds (though the contributed amount would be deducted from income when filing her taxes).
- She could invest those after-tax funds in a tax-free savings account (TFSA). Then there would be no further implications at tax-filing time.
Funding an extended absence
What if my friend was right about the summer job market? What if she couldn’t find a suitable position as the fall months rolled on? Without an emergency fund, terminal payments earmarked for savings could be needed for current expenses.
Suppose she chose the RRSP route. As she would be subject to withholding tax (see table, “Withholding tax rates”) on a withdrawal from an RRSP, she would have to withdraw an amount greater than her specific need to net down to the necessary spendable cash. In the extreme, she would have to withdraw more than the original contribution to return to her initial cash position.
Even worse, she would still pay tax on that RRSP draw if the withholding tax fell short of the actual tax due when she files her tax return. And what if she continued to be on the job hunt into the new year? On top of that, the exhausted RRSP room is non-recoverable.
This situation is ideal for using a TFSA for at least a portion of the savings allocation. If unemployment continues, then a withdrawal is less complicated and less costly. There is no withheld or outstanding tax, and the withdrawal amount is a credit to future TFSA contribution room.
And if she is back on the job sooner than expected — as she is, by the way — she can transfer TFSA savings to her individual RRSP, once she’s comfortably settled into her new position.
Table: Withholding tax rates for RRSP/RRIF withdrawals
Amount General Quebec
Up to $5,000 10% 21%
> $5,000 to $15,000 20% 26%
> $15,000 30% 31%