Withdrawing funds early from your Registered Retirement Savings Plan, or RRSP, may seem like an easy source of money. Unfortunately, when you do so, you will most likely pay a penalty, so you may want to rethink using your RRSP like an ATM, or cashing out the RRSP early. Just because you can do this, doesn’t mean you should.
TL;DR (Too Long; Didn't Read)
Cashing out an RRSP will cost you money in the long run. How much depends on how much you take out. You may think you're paying money back to yourself, but you will never get back the amount of money you would have earned if you left your RRSP alone and used another source for a loan.
Early RRSP Withdrawal Penalties
Withdrawing funds from your RRSP before retirement may seem like a small amount in the present, but you will likely lose a lot of money in the long run. RRSP earnings are compounded, which means that simple earnings add up more quickly over time. So even withdrawing a small amount may mean you’ll lose a lot more in earnings over the long-term. Say you withdraw $6,000 from your RRSP now. In 25 years, if you were earning an average of 7 percent each year, your RRSP will be $32,000 less than it would have been. So that $6,000 really adds up.
Also, withdrawals of RRSPs can be charged a withholding tax. If you withdraw up to $5,000, the withholding tax rate is 10 percent. If you withdraw $5,001 to $15,000, that rate is 20 percent. If you should withdraw more than $15,000, then the tax rate rises to 30 percent. These tax rates hold across Canada except for Quebec. There, the withholding tax rate is 5-to-15 percent, and Quebec then applies a provincial tax rate on top of the withholding tax rate. So you’re paying an immediate tax, and then potentially more at tax time. That’s a lot of penalty dollars.
That isn’t all. Whatever amount you withdrew is also included in your taxable income for the year. That means if your marginal tax rate is higher than the withholding tax rate, you’ll have to pay the extra tax at the end of the year. So you’re probably already paying more than you’d pay if you took out a loan.
Another wrench will occur if you withdraw from a spousal RRSP. If you’re making contributions to a spousal RRSP and your spouse withdrew money from the RRSP, some or all of the RRSP may be included in your taxable income and not that of your spouse. This may mean extra taxes for your family, especially if you are in a higher tax bracket than your spouse.
Also, when you withdraw money from an RRSP, you permanently lose the ability to contribute that amount back. You can continue to make your maximum contributions, but you cannot contribute again the amount you withdrew, which will reduce the value of your RRSP when you retire. Once that money is removed from your account, you will not be able to put it back in.
RRSP Withdrawal Without Tax Penalty
If your RRSP withdrawal is to buy a home or pay for an education, you might not have to pay these penalties.
The Home Buyers’ Plan means that if you or your spouse hasn’t owned a home in the past five years, you and your spouse can each withdraw up to $25,000 from each of your RRSP accounts. So borrowing against an RRSP for a down payment will not carry the same penalty as other withdrawals. There will not be a penalty as long as you repay the amount borrowed within 15 years. You’ll still lose the compounded interest income on that money, but you won’t be paying tax on the money, and the investment in a home may be worth it.
The Lifelong Learning Plan allows you to withdraw up to $10,000 per year for a four-year period, as long as you don’t withdraw more than $20,000 to pay for the education of you or your spouse or your common-law partner. You are not permitted to use this money tax-free to pay for a child’s education. The full amount must be repaid within 10 years, but you do not have to start repaying the money for the first five years. However, you’ll lose the tax-sheltered compounded growth on your retirement savings while you repay the loan. The earlier you repay the loan, the less compounded growth you’ll lose.
When You Need Money
If you find you need some emergency money, you could consider taking money out of your tax-free savings account, or TFSA, as long as you repay the money the next year. Also, to lessen the cost of investment growth, you should repay the account as soon as you can.
Consider using non-registered financial assets, like guaranteed investment certificates, segregated funds or savings bonds. If you can, you should use these before you tap into your RRSP.
Also, consider taking out a line of credit if you need a way to tap into emergency cash. You’ll be able to get to the funds when you need them, without having to re-apply each time. Also, lines of credit usually carry a lower interest than fixed term loans do. Also, your interest rates are likely to be lower.
If you have the discipline to pay off an RRSP loan, you might be better off seeing if you could cut your monthly expenses, and save the money for an emergency.
There may be a few advantages to tapping into some of your RRSP early if taxes are your concern. One example would be if you were taking parental leave, your earnings will drop, and your withdrawal will get taxed at a lower rate. Also, if you have a pension plan at work that will put you in a higher tax bracket after retirement, there may be some advantages to withdrawing part of your RRSP before retirement age.
A sad reason to withdraw your money would be if you have an illness and do not expect to survive until retirement. In that case, you may want to use the money to cover medical or other expenses.
But for most of us, it would be cheaper to use a line of credit, or even credit cards, to cover a debt than repay an RRSP, and you won’t lose out on the retirement nest egg you’re building up.
Because money put into RRSPs is tax-deferred, as is the long-term compounding, most people will be better off putting money into an RRSP rather than investing it another way. It’s also a myth to think that you’ll be better off paying down debt than paying into an RRSP.
In 2017, nearly four in 10 Canadians, or 38 percent, withdrew money from their RRSP early, and almost one-fifth of them don’t expect to put back the money they’ve taken out, according to the CBC and a poll commissioned by the Bank of Montreal.
Two-thirds of Canadians think Tax-Free Savings Accounts are superior to RRSPs because they are tax-free, although TSFAs don’t provide a tax deduction upfront, while an RRSP does. TSFAs have a $5,500 contribution limit and a cumulative limit of $57,500. Thirty-nine percent of Canadian adults surveyed by Angus Reid Forum in early 2018, according to the Financial Post, believe there’s no point in investing in RRSPs, while 51 percent say RRSPs are among their top sources of income. Most Canadians no longer have Defined Benefit pension plans.
More interestingly, according to a 2017 Ipsos poll conducted by RBC, one in five Canadians hasn’t thought about retirement. Although about half of Millennials think home ownership is a top priority, only 38 percent put money into an RRSP. About half of Millennials, however, see reducing debt as a priority.
- Get Smarter About Money: Making RRSP Withdrawals Before You Retire
- The Globe and Mail: Early RRSP Withdrawals Can Bring Advantages
- Financial Post: Should You Raid Your RRSP To Pay Debt?
- Financial Post: The Five Biggest RRSP Myths That Canadians Can't Stop Repeating
- Financial Post: Almost 40 Percent of Canadians See 'No Point' in Investing in RRSPs -- Here's Why They're Wrong
- RBC: Millennial Money Dilemma: They Know What They Want in Life, But Not Always How To Save For It -- RBC Poll
- CBC: Thirty Eight Percent of Canadians Dip Into RRSPs Early, BMO Survey Suggests
Karen Gardner is a former feature editor and writer and is now a freelance writer. She looks forward to doing her family's taxes each year, and likes to write about home finances and money subjects for the rest of us.