For many folks, the prospect of withdrawing RRSP money to finance a trip, pay down debt or buy a car is tempting.
While a lump-sum withdrawal from a registered retirement savings plan before retirement age can sometimes make sense, the downsides can be serious, financial advisers say.
"It should be the last resort in most cases," says Jamie Golombek, managing director of tax and estate planning for CIBC Wealth Advisory Services.
First, taxes must be paid on the amount withdrawn. Some people may be surprised to discover they have to pay income tax on top of the government-withholding tax taken off by the financial institution on an early lump-sum withdrawal.
The withholding tax ranges from 10 to 30 per cent, depending on the lump-sum amount. In Quebec, residents pay a rate ranging from 21 to 31 per cent because the percentage also includes a provincial tax that is withheld.
"If you take out $5,000, you pay a 10-per-cent withholding tax [outside Quebec]," Mr. Golombek said. "But you could end up paying over 50 per cent or more, depending on your tax rate. The tax rate in half of the provinces is over 50 per cent for the top bracket. You will have a huge surprise when you fill out your tax return."
Other disadvantages to early withdrawals are that the recipient also loses "the tax-free growth while it is outside the RRSP," he says. And you lose the contribution room, and must work – and earn – to add more.
Those in need of cash do have options, however. Two federal programs allow people to take money out tax-free from their RRSP. Under the Home Buyers' Plan, one can borrow up to $25,000 ($50,000 for a couple) to buy a first home.
"If someone needs extra money to buy their home, and maybe to avoid the [mortgage loan] insurance associated with a high-ratio mortgage, then I think that is an excellent strategy," Mr. Golombek said.
The loan from the RRSP must be repaid over 15 years. If the RRSP holder misses a yearly payment, then that amount is included in the person's tax return as income for that year, he noted.
Similarly, the Lifelong Learning Plan allows people to borrow $10,000 a year to a maximum of $20,000 from their RRSP to finance full-time training or postsecondary education. The amount must be paid back over 10 years. "If you have to get a student loan – and rates on that are high – then maybe it is better to use money you have in your RRSP to pay for your education," Mr. Golombek said.
Early RRSP withdrawals can also be an effective strategy for people who are in a lower tax bracket after losing a job or going on maternity or paternity leave, but who contributed to their RRSP when they were in a higher bracket, he said.
"You actually get a tax benefit here. What you lose, of course, is tax-free compounding as long as that money has been withdrawn. If you have lots of unused RRSP [contribution] room, there is no issue."
Don't rely on an RRSP as an emergency fund if you can get other sources of cash, such as from a secured line of credit, or a tax-free savings account (TFSA), he said. "When you take money out of a TFSA, there is no tax on the withdrawal, and of course you can put the money back starting the following calendar year."
For people paying 20 per cent or higher in interest rates on their credit cards, withdrawing from their RRSP to pay them off could be worth it, Mr. Golombek suggested. "You might as well take it out. You are not earning a 20-per-cent rate of return guaranteed in your RRSP no matter what you are investing in."
When people tap into their RRSP before retirement, that "defeats the purpose of an RRSP, which was really designed as a retirement vehicle," said Jim Yih, an Edmonton-based fee-only financial planner. "But a lot of people use it to pay their bills, go on a trip or fund their lifestyle before retirement."
However, more people should consider making RRSP withdrawals after they stop working and before they reach age 71, when the plan must be converted into a registered retirement income fund (RRIF) or other retirement income option, he said. "As soon as you retire, you need to develop an RRSP withdrawal strategy."
Younger retirees will be in a lower marginal tax bracket, so the hit to their income will be less onerous, and they are usually in better health and thus able to enjoy some of their nest egg, said Mr. Yih, who also runs a personal finance blog called retirehappy.ca.
The problem, he said, is that many retirees won't take money out of their RRSP because they fear they will spend their nest egg too quickly, or they don't want to pay the tax, or they don't need the money because they have other pension income.
The result is that retirees can find themselves nudged into a higher tax bracket when they begin to receive monies from more sources, such as the Canada Pension Plan and Old Age Security. "[All the income] can sometimes push you into the OAS clawback zone," said Mr. Yih, referring to high-income earners over the age of 65 who have to repay some or their entire OAS pension back to Ottawa.
Adrian Mastracci, president of Vancouver-based KCM Wealth Management Inc., is not a fan of early RRSP withdrawal unless it can be done tax free.
Those who are 65 and relying on their RRSP for their retirement income might qualify for the $2,000 Pension Income Tax Credit, he said. By transferring a small portion of an RRSP to a RRIF, one could receive $2,000 a year in tax-free withdrawals, he said. "If you have a spouse [in a similar situation], you could aim for $4,000 a year."
But he disagreed with any notion of taking money out early simply to "artificially reduce the size of an RRSP" in order to reduce taxes. "The question is really what you will need down the road," he said.
Retirees face too much uncertainty about the future rate of inflation, health-care costs and potential expenses from moving into a retirement home, said Mr. Mastracci, who has some clients living well into their 90s. "Nobody knows what the future will bring."