The COVID-19 pandemic has led some Canadians to consider dipping into their savings to cover income loss, health issues and other unexpected expenses.

Depending on your financial situation, pulling money from your savings account or emergency fund may be a good way to put your finances back on track. But is it smart to make early withdrawals from a registered retirement savings plan (RRSP)? In most cases, the answer is no.

Early withdrawals from RRSPs have hidden costs that can damage your retirement plan. Here’s what you need to know before you consider dipping into your nest egg.

What happens when you withdraw money from your RRSP early?

It’s important to remember that early withdrawals from RRSPs have three 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.

(*Compounding is what happens when your investment earnings or savings account interest is added to your original contribution.)

The investments you have growing in your RRSP are tax-deferred or sheltered from tax until withdrawal. This means you won’t be taxed on the money growing in an RRSP until you withdraw it. 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, let’s say you withdraw $6,000 from your RRSP now, after 25 years (assuming you earn a 7% return each year). In this case, your RRSP will have over $32,000 less in it than if you hadn’t made that $6,000 withdrawal.

2. Your RRSP 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%.
  • 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. In Quebec, 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tax rate* is higher than the withholding tax rate, you’ll have to pay additional tax at year-end on the funds you’ve withdrawn.

(*The marginal tax rate is the amount of additional tax paid for every additional dollar earned as income.)

And withdrawals from a spousal RRSP can carry additional risks as well. Let’s say 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’re in a higher tax bracket than your spouse. In such cases, it’s best to check with an advisor before making a withdrawal, to find out how it will affect you.

  • An advisor can help you manage your finances and make the most of your investments. Most advisors now offer to meet Clients virtually by video chat. Connect with an advisor today.

3. Permanent loss of RRSP contribution room

Do you know what happens 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. You can do this as long as you or your spouse have not owned a home in the past 5 years. You must also 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). You can use this money to pay for the education of you or your spouse or your common-law partner (not your child). You must also 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. You won’t lose contribution room with these withdrawals. But 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 can you do 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. Here are some options you can turn to when money’s tight:

1. 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.)

2. Withdraw funds from non-registered assets, like guaranteed investment certificates (GICs), segregated funds or savings bonds.

If you have these assets, 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’ll give up the potential investment earnings).

What if you had earmarked these funds for retirement? Then you may have to adjust your retirement savings plan to ensure that you’ll still have enough funds to afford the lifestyle you want.

Has a financial emergency recently left looking for an ongoing source of cash? Start by re-evaluating your budget and temporarily reducing expenses you don’t need. For example, has the pandemic left you working from home or kept you from social events? Then you’re probably saving money you may have previously spent on transportation to work or entertainment.

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The information presented in this document is for general information only. Sun Life does not provide legal, accounting, taxation or other professional advice to advisors or their Clients. Before you act on any of the information contained in this guide, please get advice from qualified professionals. Tax and accounting professionals, along with your advisor, can thoroughly examine your situation and provide you with the best insurance and tax planning option suited to your needs.