Canada’s unemployment rate rose to an 11 year high of 8.6% – the highest rate since February 1998. Many Canadians are feeling the crunch and are looking for ways to reduce their debt and possibly avoid personal bankruptcy.
If you are thinking of withdrawing from your RRSP to pay off your debts, you should think about some of the other consequences of doing so. There may be alternatives to reduce your debt without withdrawing from your retirement funds.
Taxes And RRSP Withdrawals
When you withdraw funds from your RRSP, your financial institution will withhold a portion for income taxes. These withholding taxes are as follows:
| up to $5,000 | 10% |
| $5,001 to $15,000 | 20% |
| $15,001 and up | 30% |
In Quebec, the withholding rate is ½ of the percentages in this table.
If you have $20,000 of debt, you would need to withdraw at least $28,600 from your RRSP.
You might be thinking: “I could just do four $5,000 withdrawals?” By doing so, you only need to withdraw a little over $22,000 right?
Well, the amount of your RRSP withdrawals will be added to your taxable income and if not enough tax was withheld, you could be hit with a tax bill at the end of the year.
An Example
Jim earns $40,000 and needs $20,000 to pay off his debt. If Jim does a lump sum withdrawal of $28,600 he will receive $20,000 to pay off his debt. At the end of the year, Jim’s employer would have remitted $6,400 of tax for his employment income and the bank would have withheld $8,600 for his withdrawal. His taxable income would be $68,600 and would still owe $360 to the government as a result of the withdrawal.
On the other hand, if Jim decided to do four withdrawals of $5,600 each, the total tax withheld would only be $2,200. At the end of the year Jim would owe the government an additional $5,300!
What Are The Alternatives
I am of the opinion that an RRSP you should never withdraw from your RRSP to pay down personal debt! Think about the following alternatives to withdrawing from your RRSP:
- RRSPs & RRIFs are Creditor Protected. If you find yourself unable to pay your creditors, you may be facing bankruptcy. Know that if you go into bankruptcy, RRSP contributions made more than 2 years prior to bankruptcy cannot be touched by your creditors.
- Consolidation Loans. If you still have good credit and are finding that your debt payments are getting out of control, consider consolidating your debts into a single payment. The single payment should be lower than your combined payments and the term of the loan is fixed (so there is an end in sight). If you consolidate, take steps to eliminate your credit cards and other lines of credit so you don’t find yourself in this situation again.
- Consumer Proposal To Creditors. If you are unable to get a consolidation loan, you should consider seeking the help of a consumer credit counsellor and make a proposal to creditors. The proposal can reduce the amount you pay and avoids bankruptcy. However, a consumer proposal will show on your credit report and affect your credit rating for 3 years.
- Bankruptcy is a process of eliminating your debts. With bankruptcy personal assets may be sold to satisfy all or some of your debts. Contributions made your RRSPs more than two years ago will be exempt from your bankruptcy and certain other personal assets (varied by province).
Share Your Thoughts
Do you have an innovative way to reduce or eliminate debt? Do you think you should withdraw from an RRSP? Share your thoughts with others by leaving a comment.
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{ 18 comments… read them below or add one }
Hello everyone,
I have a client who wants to cash in all his RRSPs in a 7 year period which relates to when he’ll begin drawing a pension, to prevent further taxation on his pension + RRIF income + OAS CPP etc. My question is this: All term certain annuities don’t allow RRSPs to be invested for period of 10 years if you’re under 55. All GIA accounts and RRIFS are paying peanuts unless you have $1 million, and most GIA accounts have market value adjustments, which also means the clients make less money. Do you know of any affective strategies people are doing today to get around this and make a pretty good return?
Please email me your comments.
Your Insurance Guy (yourinsuranceguy@rogers.com)
@ Your Insurance Guy:
The risk tolerance of your client will help determine which investments are suitable. There are other investments other than GIA’s that yield higher returns (I currently hold a Manulife Bond with close to 8% yield).
A meltdown strategy would only make sense if the client expected to be in a higher income range in retirement. However, CPP and OAS plus his pension will propbably brign him under his current income.
To follow up on the ‘cash out RRSP’ thought, what about this scenario (hypothetical, of course)……
I have ~$35,000 in credit card debt. I also have ~$40,000 in RRSP (mutual funds). Would it make sense to cash out the RRSP to pay off the debt, and then use the $1000 per month I am currently spending on the credit cards to put back into the RRSP? I would be back to my $40,000 level within 3 years, and saved the interest charges for that time. Also, even though I pay tax on the initial withdrawal right now, I would gain it back through the amounts I put into the RRSP over the next 3 years, so the net effect is $0.
Is this correct, or am I missing something?
@Robert: The $40,000 would be included in your income for tax purposes and 40% would be withheld. Only $28,000 would be available for debt service and you would have to still pay off $7,000 of debt. You may also have a tax liability as the 30% withheld may not have been enough (it really depends on your taxable income).
You have also lost $40,000 of RRSP contribution room you may never get back and you would need to ensure you make more than $66,000 per year (or have unused room available) to be able to contribute $1,000 a month.
Assuming a return on the RRSP of 7% and 20% rate on the credit card. If you used the $1,000 a month to pay down the credit card it would take 53 months to pay it off and at the end of that period the RRSP would be worth $52,000.
Instead, if you cash out the RRSP, use the $28,000 to pay down the credit card, and use the $1,000 to pay off the remaining debt then contribute to the RRSP, the RRSP would be worth $51,300 after the same period of time.
Of course the above ignores the tax consequences, but I’d say pay off the $35,000 a $1,000 month and at time and after it’s paid contribute to the RRSP. You may be able to make a catch-up RRSP loan and use your excess contribution room.
Many thanks!!
I read the dialogue on cashing in RSPs to pay off debt, and the tax implications alone might be enough to scare me away from doing this, but I have a question.
The last year has been very hard on me because my RSP investments are really small — too small to ever turn into an annuity. When I retire with my employer pension in a few years, I’ll be 55. I’ll still work somewhere, but I’ll likely earn a fraction of what I earn now. I know taking out my RSPs then won’t hurt so bad tax-wise, but I’ll have lost a lot of money to interest payment on debt.
Given that there is no guarantee that some market meltdown won’t eat up another third of my meager RSP savings, maybe I’d be better off paying the government to waste my money, pay less in interest to the banks who don’t need my money and just getting by with my pension and supplemental employment.
The scenario about the $40k in RSP and $35K debt would be close enough to my own. Is this all just a matter of how well I’m willing to tolerate risk over the next 4 years until I retire?
Thanks. I’ve appreciated the conversation on this topic very much.
@Stephanie: My discussion with Robert assumed a relatively conservative rate of return of 7%. So risk is moderate. If you are going to retire in a few short years, it may make sense to cash out the RSP and pay down the debt. You can easily estimate the tax short fall. My biggest issue with the strategy is using your retirement savings for debt and giving up RRSP contribution room. If you are going to retire in the next few years, the situation is a little different: Your time horizon is shorter and you should retire as debt free as possible.
With the new bankruptcy law contributions made your RRSPs more than one years ago will be exempt from your bankruptcy. There are other changes too but one of them is that contributions made 12 months ago are exempt from bancruptcy.
Does the fact tha the actual cash value of an RRSP is less than the bookvalue affect how taxable the money would be if cashed in?
Roger: The concept of the RRSP is that you deduct contributions to the account from your taxable income and add withdrawals to taxable income. Gains and losses inside the RRSP are not taxable and have no tax implications.
10 years ago, I moved to australia, I now live here permanently.
I have found out I have a long lost rrsp account with tdwaterhouse. I have sold out all my stocks and would like to transfer the money made (16 000) here to Australia.
I will not be returning to Canada and would like to make use of the money here.
Can you tell me how much I will owe the government? Or can you recommend the best route for me to go down
Thanks
Robyn:
TD will probably withhold 25% on a lump sum withdrawal. You may have to claim the cash out in Australia.
I am in a similar situation as @Robert:
Did you mean to pay off the CC debt, and then rebuild the RRSP’s. You get a little confusing there near the end. It seems a better way to go to be out of debt. I mean you lose that contribution room, but you are also estimating a 7% rate of return, which is pretty hard to guarantee over the next 53 months.
Of course I am ignoring the tax consequences beyond the 30%, but also ignoring the positive consequences of the continued RRSP payments in reducing future tax payments.
Hello Bob:
The long term rate of return on investment is about 7%. This an opportunity cost, not a guaranteed rate over the next 53 months. If the money were left alone in the RRSP until retirement, a reasonably diversified portfolio of stocks would generate 7%.
What are the tax implications if I withdraw funds from my rrsp now, but replace them before the end of the year? Can I do this?
As you can see, I have some short-term cash requirements, that will return to me within this year.
The tax implications are simple, if you withdraw $5,000 and contribute $5,000 the taxes are neutral. The problems is that the financial institution will have to apply withholding tax. You will have to withdraw $5,882.35 to get $5,000. So you end up with $5,882 included in income and will only contribute $5,000 back. You have $882 taxed as income.
Can you borrow the funds from a family member?
What are the tax implications if I have had no employment income for 2009 and 2010 and I cash in a 50K RRSP. I would use this money to pay down credit card debt of about 35k.
The full amount of RRSP withdrawal will be added to your taxable income for the year. The plan provider will withhold 30% and you will end up with $35,000 after the withholding. Depending on how much other taxable income you have, the 30% ,may or may not be enough.