An RRSP No-No: Don’t Make Early Withdrawals
June 10th, 2016
A large number of Canadians are prematurely dipping into their Registered Retirement Savings Plans (RRSPs).
A recent poll conducted by Pollara for Bank of Montreal (BMO) showed that 34% of Canadians have withdrawn money from their RRSPs before retirement.
According to the survey, the average withdrawal totaled nearly $16,000. A third of the borrowers have paid back the money, but 25% say they don’t expect to ever pay it back.
The top reasons for these premature withdrawals ranged from buying a home (25%) to paying off debt (21%), covering living expenses (21%) and paying the costs related to emergencies such as car accidents or house floods (15%).
“It’s clear that some Canadians have had to [withdraw funds early] in order to meet short-term needs,” said Chris Buttigieg, senior manager of wealth planning strategy at BMO. The problem is there are significant tax and financial consequences for early withdrawals.
Of those who withdrew funds from their RRSPs, 84% did it as a last resort, according to the survey. Many said they were worried about the consequences, which include:
- Loss of retirement income (79%),
- Tax on the money withdrawn (77%),
- Inability to save effectively for retirement (77%), and
- Loss of future contribution room (62%).
The main advantage of an RRSP is tax deferral. The money in the plan can grow and isn’t taxed until it’s withdrawn. Another advantage is the tax deduction. Your taxable income is reduced by the amount you contribute up to a limit. The idea is that the money will be taxed when you retire and your income and marginal tax rate will be lower than during your peak earning years when you can claim tax deductions.
Your RRSP has an added benefit of allowing you to carry forward unused contribution room indefinitely.
This chart breaks down the withdrawals by region:
Most savers didn’t need a crystal ball to realize there would be consequences. Most said they knew it wasn’t a good idea to withdraw money from their RRSPs before retirement, because taking money out prematurely can have significant tax and financial penalties.
First, there are withholding taxes. Your financial institution will hold back taxes on the amount you take out and pay them to the government on your behalf.
On top of that, you’ll have to report the amount you take out on your tax return as income. At that time, you may have to pay more tax on the money in addition to the withholding tax paid earlier.
Lost Contribution Room
Once you’ve withdrawn the money, you lose the contribution room of those funds permanently. If you take out $10,000, you’ll never be allowed to re-contribute it, which reduces the potential value of your total RRSP at retirement. Once the money is out, you have to start over again to save it and you lose the compounding growth that you could have gotten if it had stayed in.
Two exceptions are withdrawing funds and investing in the first-time Home Buyers’ Plan, which allows you to withdraw certain amounts from your RRSP to buy your first home, and the Lifelong Learning Plan, which allows you to take out money to go back to school. Both plans don’t involve withholding tax but require you to repay the money within a certain time. If you fail to repay the money, or any part of it, the amount is added to your income and taxed.
While paying off debt is one of the reasons some people dip into their RRSP early, an alternative to consider is to make the contribution and use your tax refund to pay the debt. You could also discuss with your adviser if it makes sense to consolidate your debt with a loan where you have just one payment at a much lower interest rate than you pay on all your other debts combined.
Another option to consider is a line of credit. A personal line of credit lets you borrow a specific amount, but you aren’t charged interest until you use the money. The interest rate on a line of credit is generally lower than most credit cards, so one strategy is to open a line of credit with a low interest rate to pay off those high-interest debts.
There are additional ways to help prepare you financially for retirement such as pre-retirement investment strategies, critical illness insurance and, of course, Tax-Free Savings Accounts (TFSAs). The registered accounts allow you to save as much as $5,500 a year.
Unused contribution room can be carried forward indefinitely. TFSAs allow you to earn money in the accounts and withdraw it tax-free. Just be careful to follow the repayment rules closely. If your contributions exceed the limit, you could be subject to a 1% penalty tax on the highest excess amount in the month of the contribution.
Your financial adviser can help you determine the right strategies and investments for both the years before you retire and after you stop working.