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Retirement savings

January 22, 2018

The hidden costs of early RRSP withdrawals

RRSPs are excellent savings vehicles for retirement, but early withdrawals from these tax-sheltered accounts can affect your tax bill right now.

Early withdrawals from registered retirement savings plans (RRSPs) are increasingly common, but are they smart? In most cases, the answer is no. Early withdrawals from RRSPs have hidden costs that can damage your retirement plan.

The consequences of withdrawing from your RRSP early

Early withdrawals from RRSPs have 3 major costs:

1. Loss of tax-sheltered compounding

When you withdraw funds from an RRSP, you lose one of the main benefits: the tax-sheltered compounding of earnings. Your RRSP earnings are sheltered from tax until withdrawal, and because of the effects of compounding, the withdrawal of even a relatively small amount can have a substantial impact on the long-term value of your savings.

For example, if you withdraw $6,000 from your RRSP now, after 25 years (assuming you earn a 7% return each year), your RRSP will have over $32,000 less in it than if you hadn’t made that $6,000 withdrawal.

2. Withdrawals are taxable

Any withdrawals from your RRSP are immediately subject to withholding tax. If you withdraw up to $5,000, the withholding tax rate is 10%; if you withdraw between $5,001 and $15,000, the withholding tax rate is 20%; and if you withdraw more than $15,000, the withholding tax rate rises to 30%. Note that these tax rates apply to everywhere in Canada except Quebec, where provincial tax rates apply on top of the federal withholding tax.

But the taxes don’t end there. The amount of the withdrawal is also included in your taxable income for the year, so if your marginal tax rate is higher than the withholding tax rate, you’ll have to pay additional tax at year-end on the funds you’ve withdrawn.

And withdrawals from a spousal RRSP can carry additional risks. If you’re making ongoing contributions to a spousal RRSP and your spouse withdraws funds, depending on the timing, all or a portion of the withdrawal will be included in your taxable income and not your spouse’s. This may result in an additional tax implication for your family if you are in a higher tax bracket than your spouse. Best to check with your financial advisor before making a withdrawal, to find out how it will affect you.

3. Permanent loss of contribution room

When you withdraw funds from an RRSP, you permanently lose the contribution room you originally used to make your deposit. While you can continue making your maximum contribution to your RRSP in the future, you can’t re-contribute the amount you withdrew. This reduces the potential value of your RRSP at retirement.

How to withdraw from your RRSP without a tax penalty

There are certain situations where early withdrawals from an RRSP may provide benefits. The government treats withdrawals to buy a home or finance your education differently from other early RRSP withdrawals:

  • The Home Buyers’ Plan (HBP) lets you and your spouse borrow up to $25,000 from each of your RRSPs to build or buy a home, as long as you or your spouse have not owned a home in the past 5 years. You must repay the amounts borrowed to your RRSP within 15 years. 
  • The Lifelong Learning Plan (LLP) lets you withdraw up to $10,000 per year for a 4-year period from your RRSP (to a maximum of $20,000) to pay for the education of you or your spouse or your common-law partner (not your child). You must repay the full amount within 10 years.

Funds withdrawn under the HBP and LLP are not taxable, as long as you repay them on time. But while you don’t lose contribution room with these withdrawals, you will lose several years of tax-sheltered compounded growth on your retirement savings while you repay the loan. The faster you can pay the money back, the less growth you’ll lose.

What if you need emergency funds?

If a financial emergency arises and you need cash, there are some alternatives to consider before withdrawing your retirement savings.

  • Take money out of your tax-free savings account (TFSA). A TFSA is a good place to keep an emergency fund, as you can put back any money you take out the following year. (But be sure to repay your TFSA promptly, to minimize the loss of investment growth.)
  • If you have non-registered assets, like guaranteed investment certificates (GICs), segregated funds or savings bonds, consider using them before touching your RRSP. Unlike withdrawing funds from an RRSP, withdrawing funds from these investments won’t increase your taxable income (although you will give up the potential investment earnings). If you had earmarked these funds for retirement, you may have to adjust your retirement savings plan to ensure that you’ll still have sufficient funds to afford the lifestyle you want.

If a financial emergency has you looking for an ongoing source of cash, start by re-evaluating your budget and reducing unnecessary expenses such as eating out, shopping and entertainment, to reduce the amount of cash you need.

If you must borrow money, consider a line of credit, which will allow you to access funds when you need them without having to reapply for a loan each time. Lines of credit generally offer a lower interest rate than fixed-term loans, and if secured by another asset such as your home, may have interest rates as low as prime.

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