A Statistics Canada study indicates that more Canadians are cashing in their RRSP savings long before they reach retirement.
The money tucked away in your Retirement Savings Plan can be a tempting source of cash. But think twice before withdrawing money from your retirement nest egg. The amount you withdraw is considered income for that year and taxed accordingly.
Unless the withdrawal is made under the Home Buyers’ Plan or the Lifelong Learning Plan, you’ll immediately be hit with a hefty withholding tax, which may not cover all the tax payable. Over the long term the cost of dipping into your RRSP early is even higher.
Trying to save on interest costs
Early withdrawals from your RRSP have hidden costs that can do long term damage to your retirement plan. Consider this example:
Jason has diligently contributed to his RRSP every month and now has a sizable investment of $100,000. He wants to buy a new car and needs $25,000.
Related: Is An RRSP Loan Necessary?
He can take out a loan, but he doesn’t want to pay the loan interest. On the other hand he can use some of his retirement savings. After all, he thinks he still has lots of time to save before he’ll need the money for retirement. What’s the best option?
If Jason takes out a $25,000 loan at an annual rate of 7.5 % over 5 years, he’ll pay about $5,060 in interest costs.
If he taps into his RRSP to buy the car, he’ll actually have to withdraw $35,715 ($25,000 plus $10,715 to cover the mandatory 30% withholding tax). This leaves his RRSP with $64,285.
Assuming the remaining balance grows at an annual compound rate of 4% over the next five years, his RRSP will increase in value to $78,212.
If he had left his plan intact, he would have $121,665.
In other words, the loan would cost about $5,000 in interest over five years while the RRSP withdrawal would cost him more than $43,000.
Related: Is Your Investment Loan Tax Deductible?
This doesn’t take into account any additional income tax that may apply when filing his tax return and, unlike with a TFSA, there is no opportunity to replace the borrowed money, as the contribution room will be lost.
Over 20 years, the cost of the lost compounding rises to $95,208.
Using government programs
An RRSP withdrawal made through the government’s Home Buyers’ and Lifelong Learning programs is not subject to withholding or income tax. However, you have to repay the money in equal installments over the next 15 years.
If you miss a repayment, the amount will be added to that year’s income and taxed at your marginal tax rate.
Many will argue that higher education is an investment in greater future earnings and a house is an asset that will appreciate over time.
Also, borrowing from savings to purchase a house will allow you to make a more substantial down payment which enables you to avoid or reduce CMHC mortgage insurance fees and build the equity in your home faster.
Related: Why You Should Avoid Mortgage Life Insurance
However, the combination of a large withdrawal and a slow repayment schedule can have a significant impact on the growth of your retirement savings so think it through carefully.
While you don’t lose the contribution room, you will lose several years of tax-sheltered compound growth while you repay the loan. The faster you’re able to pay the money back, the less growth you will lose.
Conclusion
Dipping into your RRSP for quick cash may seem tempting, but is it a wise move financially?
Over the long run it will likely prove to be very costly and will damage your retirement plan. The withdrawal of even a small amount can have a substantial impact on the value of your savings and you will have to adjust your plan to ensure that you’ll still have sufficient funds to afford the lifestyle you want.
But what if you need funds? If a financial emergency arises and you need cash, look at other alternatives first before making an RRSP withdrawal.
Consider your non-registered assets or TFSA. A line of credit will offer a lower interest rate than a fixed term loan.
In most cases, though, it’s better to use the many different, more suitable, savings options available to you for both emergencies and future purchases.
