When an employment relationship ends, the dollar figure on the termination letter is only half the story. What actually lands in the departing employee's bank account, and what the employer needs to report and remit, depends heavily on how the payment is classified under the Income Tax Act, a distinction that has nothing to do with what the severance package is called in conversation[1].

Key Takeaway

Pay in lieu of notice is ordinary employment income, subject to CPP and EI like any regular paycheque. A true retiring allowance is not subject to either. On a $50,000 payment, that distinction alone is worth approximately $3,500 in avoided payroll deductions, and it is determined by the legal nature of the payment, not by what either side prefers to call it[2].

Three Types of Termination Payment

CRA and the courts distinguish clearly between several categories of payment that all get colloquially lumped together as "severance"[3]:

  • Pay in lieu of notice. Ordinary employment income, taxed and deducted exactly like a regular paycheque, fully subject to CPP and EI.
  • Salary continuance. Regular pay and benefits continuing for a defined period after departure; taxed like ordinary employment income for as long as it continues.
  • Retiring allowance (true severance). An amount paid in recognition of long service or as compensation for loss of employment, regardless of whether the person is actually retiring. This category is not subject to CPP or EI at all, only income tax applies[2].

Accumulated vacation pay, sick leave credits, and standard salary continuance do not qualify as a retiring allowance. Only lump-sum damages paid specifically for the loss of employment can be legally categorized this way[4].

The CPP/EI Savings From Correct Classification

Illustrative Net Outcome: $50,000 Payment, By Classification

Net Amount Retained By Employee

Because retiring allowances are exempt from CPP and EI, correctly classifying a payment is worth real money to the departing employee, without costing the employer anything extra, since the employer's own CPP and EI matching obligation disappears along with the employee's[2]. Misclassifying an eligible retiring allowance as ordinary wages needlessly reduces the net amount both sides walk away with.

Withholding Rates vs. Actual Tax

A retiring allowance is fully taxable at the recipient's marginal rate, but employers only withhold at a flat lump-sum rate at source: 10% on amounts up to $5,000, 20% on amounts between $5,000 and $15,000, and 30% on amounts over $15,000 (outside Quebec, which uses a different federal-provincial split)[5]. Because the withholding rate is a rough estimate, not the final tax, the employee's actual liability at filing depends on their total income for the year. Someone with other income already pushing them into a higher bracket will typically owe more than what was withheld; someone in a lower-income year may see a refund[5].

T4 Box 66 vs. Box 67

A retiring allowance can include both an eligible and a non-eligible portion, and CRA requires them reported separately[6]:

  • Box 66, eligible retiring allowances. The portion that qualifies for the pre-1996 RRSP rollover, transferable tax-free regardless of the employee's available RRSP contribution room.
  • Box 67, non-eligible retiring allowances. Everything else. This portion can still be contributed to an RRSP, but only to the extent the employee has actual contribution room available, and ordinary withholding applies unless directly transferred.

Neither box 66 nor box 67 amounts are included in Box 14 (employment income) on the T4, since retiring allowances are reported and taxed separately from regular wages[6].

The Pre-1996 RRSP Rollover

Under paragraph 60(j.1) of the Income Tax Act, an employee can roll part of an eligible retiring allowance directly into an RRSP without needing any contribution room at all, an increasingly rare but still valuable benefit for long-tenured employees[7]:

  • $2,000 for each year or partial year of service with that employer before 1996.
  • An additional $1,500 for years before 1989 in which the employer's pension contributions had not yet vested in the employee, for up to $3,500 per pre-1989 year.

A direct transfer using Form T2151 avoids income tax withholding entirely on that portion. Because this rollover only applies to service before 1996, it affects a shrinking share of the workforce each year and is now most relevant to long-tenured employees nearing the end of multi-decade careers[8].

The 2026 RRSP Room as the Modern Shelter

For most employees today, the pre-1996 rollover window no longer applies, which makes ordinary RRSP contribution room the primary tax deferral tool available on a severance payment. The 2026 RRSP dollar limit for new contribution room is $33,810, on top of any unused room carried forward from prior years[9]. Sheltering a meaningful portion of a severance payment inside available RRSP room defers tax on that amount until withdrawal, a strategy that is particularly effective when the employee expects to be in a materially lower tax bracket in a future year, during a job search, a sabbatical, or after retirement[9].

Statutory Minimums vs. Common Law

Provincial employment standards set only the legal floor for termination entitlements, and Ontario is unusual in imposing two separate statutory obligations at once: termination pay (one week per year of service, to a maximum of eight weeks) and, for larger employers, separate statutory severance pay (one week per year including partial years, to a maximum of twenty-six weeks)[10]. Courts applying common law "reasonable notice," assessed through the Bardal factors, character of employment, length of service, age, and availability of similar employment, frequently award considerably more than the statutory minimum, which is precisely why accepting the first written offer without review is rarely advisable for either side[10].

Employer Reporting Checklist

Step 1

Classify The Payment Correctly

Confirm whether the payment is pay in lieu of notice, salary continuance, or a genuine retiring allowance before running it through payroll.

Step 2

Split Eligible and Non-Eligible Portions

Calculate any pre-1996 and pre-1989 service years to determine the Box 66 eligible amount.

Step 3

Apply The Correct Withholding Rate

10%, 20% or 30% based on the lump-sum amount, or none at all on a direct RRSP/RPP transfer.

Step 4

Report Boxes 66 and 67 Separately

Never include retiring allowance amounts in Box 14, and keep the two categories distinct on the T4.

Frequently Asked Questions

Can an employee split a large severance payment across two calendar years?
Yes, if the employer agrees. Since tax is owed only on income received in a given year, spreading a payment across two tax years can reduce the total tax paid by keeping more of it out of a higher bracket in any single year.
Does a wrongful dismissal settlement get the same tax treatment as a negotiated severance?
Generally yes, damages paid specifically for loss of employment are treated as a retiring allowance regardless of whether they arose from a negotiated exit or a wrongful dismissal claim, provided the payment genuinely compensates for the loss of the job itself.
Is severance paid to a non-resident reported the same way?
No. Retiring allowances paid to a non-resident of Canada are reported on an NR4 slip instead of a T4, with different withholding rules applying.
IB

About The Insight Bureau Research Desk

The Insight Bureau is GSH Financial's research publication, written by our payroll practice for Canadian employers and employees. This article reflects CRA administrative guidance and 2026 figures current as of publication; see References below.

References

  1. Canada Revenue Agency. (2026, June 1). Payments of retiring allowances. Government of Canada. canada.ca/.../retiring-allowances
  2. PayCheck Tax Calculator. (2026, February 1). Severance pay calculator Canada 2026: ESA and common law by province. paychecktaxcalculator.net/severance-pay-calculator/canada
  3. Canada Revenue Agency. (n.d.). Employers' guide: Filing the T4 slip and summary. Government of Canada. canada.ca/.../rc4120-employers-guide-t4
  4. Canada Lawyer Directory. (2026, June 17). Retiring allowances vs severance pay: Tax planning in Canada. lawyerinfo.ca/guides/.../retiring-allowances-vs-severance-pay
  5. CATaxTools. (2026, June). CRA severance/retiring allowance tax calculator 2025 & 2026 Canada. catax.tools/severance-tax-calculator
  6. Canada Revenue Agency. (n.d.). Transfer of a retiring allowance. Government of Canada. canada.ca/.../transfer-a-retiring-allowance
  7. TaxTips.ca. (n.d.). Severance or retiring allowances, defer tax. taxtips.ca/personaltax/employees/defer-tax-on-severance
  8. LifeMoney. (2026, May 29). Severance minimums by province 2026: Employment standards compared. lifemoney.ca/blog/severance-minimums-by-province-2026
  9. LifeMoney. (2026, May 29). Severance minimums by province 2026, RRSP shelter section. lifemoney.ca/blog/severance-minimums-by-province-2026
  10. Canada Calculator. (2026, May). Severance pay calculator Canada 2026, all provinces. canadacalculator.ca/severance

This article reflects CRA administrative guidance and 2026 figures current as of publication and is provided for general informational purposes. It is not tax, payroll, or employment law advice for any specific situation. Statutory minimums vary by province and common law entitlement is fact-specific, consult a qualified professional before finalizing any termination package.