Question: I am looking to make an early withdraw of $20,000 from RRSP account to pay my mortgage off but I am also planning to pay the exact amount back into RRSP account in the next few years. What are the implications?
I Live in Ontario and my annual Income is $50,000. My RRSP earns about 4% and my mortgage rate is also about 4%.
Your RRSP vs. Mortgage Options
Your overall financial planning objective is to increase your net worth (what you own less what you owe). It is important to consider other options than cashing out your the investment portfolio in your RRSP.
- Do nothing
- Withdraw from your RRSP now and pay down the mortgage. Then pay back the amount withdrawn from your RRSP over 5 years ($4,000 per year).
- Make $4,000 per year principal payments to your mortgage and forego the additional RRSP contribution.
Let’s also include some other assumptions for illustrative purposes:
- Toronto house prices have increased an average of 3.3% over the last 20 years.
- Your mortgage interest rate is 4%
- Your RRSP return is 4%
- Your timeframe is 5 years
- We’ll assume the amortization period on your mortgage is 10 years and the house value is currently $120,000.
- Since you intend to re-pay the proposed withdrawal in the next few years, we’ll assume you can contribute an additional $4,000 year to an RRSP and that you have sufficient contribution room to do so.
(Note if your average return on your RRSP is 4% over the last several years, you should look at finding an investment advisor. Ideally, you should be in the 6% to 8% range if you are more than 10 years from retirement).
1. Do Nothing
In 5 years,
- House value increases by 18% to $141,600
- At 4% per year your RRSP, plus your annual contributions will increase to $46,000.
- Your mortgage will decrease by 55% to $44,000.
Your net worth (what you won less what you owe) increases by $143,600.
Your annual tax bill, assuming only the basic tax personal credit and an RRSP contribution of $4,000, is $8,595.
2. Withdraw From The RRSP And Pay Down The Mortgage
If you withdraw $20,000 from your RRSP now, you must add that amount to your taxable income in the current year. Following the withdrawal, your taxable income increases to $70,000 and your total tax bill for the year would be $16,191.
As a result, you will really only have $13,650 available to put against your mortgage and will pay $6,350 of extra income tax. All this before you have even put any thing against your mortgage.
Putting the $13,650 against the mortgage and using an additional $4,000 per year to contribute to your RRSP, in 5 years:
- House value increases to $141,600
- RRSP value at 4% is $21,700.
- Mortgage decreases to $27,300
Your net worth would decrease to $136,000.
This strategy actually costs you $7,600 in net worth and you have paid $6,350 of additional income tax.
3. Annual Principal Payments of $4,000
Your taxable income increases because you do not make any additional contributions to an RRSP. Your annual tax bill will be $1,250 per year more. In 5 years:
- House value increases to $141,600
- RRSP value at 4% is $24,300
- Mortgage decreases to $21,900
Net worth would increase to $144,000.
The difference between option 1 and option 3 is negligible and really you should be indifferent between the two options.
Another Option – RRSP Mortgage
Rather than cash out your RRSP and pay down your mortgage, you can use your RRSP assets and then borrow from your RRSP using an RRSP mortgage. This strategy is rather conservative in terms of the investments for an RRSP, it might fit your needs.
Here is how it works:
- You sell all of the investments in your RRSP.
- You go to your bank and tell them you would like to hold your mortgage inside your RRSP.
- The bank will charge you about $250 per year to do this.
- The funds from your RRSP are then used to pay down the bank mortgage.
In your case you will now have 2 mortgages:
- The old bank mortgage at 4% but it’s now only $60,000.
- You have a second mortgage that you must pay. At current rates the interest is going to about 7% (you cannot pay your self more interest than you could obtain from a bank). But your RRSP is getting the interest tax free and not the bank.
- There are no tax consequences and you have not affected your RRSP contribution room.
- Assume you continue your existing mortgage until it is finished and your RRSP mortgage is amortized over 25 years (the longer the better with an RRSP mortgage!).
- Of the $4,000 of annual RRSP contributions would be reduced by the RRSP mortgage payments ($1,900 per year including the $250 annual fee). You then contribute the remaining $2,100 to your RRSP.
In 5 years:
- House value = $141,600
- RRSP Value (excluding the RRSP mortgage) = $35,700
- RRSP Value including the mortgage = $9,000
- Bank mortgage owed = $19,600
- RRSP mortgage owed = $18,210 (this is owed to you remember and is not a debt)
Your net worth is $166,700.
Note that I have not included the RRSP mortgage as a debt. The RRSP mortgage (a liability) is offset by a mortgage note (an asset).
Also, since you are re-paying a debt inside your RRSP with interest, you are actually contributing an extra $22,000 to your RRSP without affecting your contribution room.
RRSP mortgages are suitable for some and not suitable for others. Do your research. Here is some additional information and articles on the web related to RRSP mortgages:
- Canadian Capitalist – Mortgages in a RRSP
- Gordon Pape – RRSP mortgages: what you need to know
Tax Planning for You and Your Family 2009 – chapters.indigo.ca