Life is anything but predictable, and sometimes a curveball will come flying out of nowhere. Maybe you’re coasting along quite nicely when, all of a sudden, your furnace bites the dust or your dog swallows a tennis ball and needs emergency surgery. Whatever it is, you are now stuck with a big bill and aren’t sure how you’re going to cover the cost. The question you might be asking yourself is whether or not you should consider withdrawing money from your RRSP.
Don’t worry, I’m not going to just assume you’ll accept the short answer so, long answer time.
The biggest problem with pulling money out of your RRSP is the tax. Every time you withdraw money from your RRSP, the government requires withholding tax be taken off by your financial institution, and it is no small amount. For withdrawals less than $5,000 you will have to pay 10% tax, between $5,000 and $15,000 you’ll pay 20% tax, and for anything, over $15,000 you’ll pay 30% tax. This means that if you need $7,500, you will actually have to withdraw $9,375 from your RRSP and $1,875 of that will go straight to the government. The reason they’re charging so much tax is that money taken out of your RRSP is included in your income for the year, so CRA is actually trying to do you a favour and make sure you don’t end up with another unwanted bill in April. Depending on what your income level is, you may get some money back when you file your taxes, but you could also potentially end up owing even more.
Another issue is that you don’t get back that contribution room…it’s lost forever in the intergalactic world of lost RRSP room. You earn contribution room by working. For every dollar of income you make, you can put 18% of that into your retirement account, up to an annual maximum (for 2017 that maximum is $26,010 which would apply to anyone with an income over $144,500). Once you make a deposit that room is used up and there’s no way to get it back. If you’re more familiar with TFSA’s, then this might come as a surprise. If you make a withdrawal from your tax-free account, you get the full amount back in contribution room the following year. It might not seem like a big deal when you’re strapped for cash and far from retirement, but you could have many years of high income (here’s hoping!) in your future and want every dollar of RRSP room possible.
What other options do you have?
The best case scenario (aside from not having a broken furnace or sick dog obviously), would be to have a fully funded emergency fund that can cover you. Situations like this are exactly why people like me and other PF bloggers (here, here, and here) nag you so much about building up your e-fund…it can (and will) save you from serious headaches, like wondering if you should use your RRSP or not.
I’m going to go ahead and assume that if you are considering reaching your cash strapped hands into your RRSP, you don’t have an emergency fund at the ready. I’m not going to shame you, everyone needs to start somewhere. How about we just make a deal that you’ll start saving into an emergency fund as soon as this is settled up ok?
Not all investments have the same withdrawal consequences as RRSP’s. If you have a TFSA or just a plain old non-registered account, then those are good options to take the money from. Even if you have to sell off investments that have been growing, it’s still a better option than taking on high-interest debt.
Some mortgages have a ‘skip a payment’ option which could free up a sizable chunk of cash in your budget. Usually, you need a certain amount of equity built up before the bank will allow it but it’s worth a shot if you have a mortgage.
Sometimes going into debt will be your only option. You will want to search out the lowest interest option you can find. If you own a home, then you should first look at a secured line of credit. These will use the equity you’ve built up in your home as collateral for a loan and will come with a lower interest rate. Unsecured lines of credit do not use collateral for the loan and will charge you a higher interest rate but still lower than most credit cards. If those options are off the table because of a not so stellar credit history, then you’re looking at a credit card. Again, low interest is key. There are credit cards out there for everything from earning travel rewards to free movies, but you want to focus on those that have low-interest rates…at least until you have your balances paid off in full.
Once you’ve found the lowest possible interest rate it’s time to run some numbers…the RRSP option might not be 100% off the table just yet.
You can use this calculator to figure out how much your debt is going to cost you. Plug in the balance, the interest rate and how much you can afford to pay toward the balance each month. The calculator will determine how long that debt will take to pay off and how much interest you will pay over that term. Compare this amount to the amount of tax you will lose if you withdraw the same amount from your RRSP. It’s not quite that simple, but it’s a good start. You will still want to weigh the loss of contribution room and the lack of potential growth on the withdrawn amount. My suggestion, if the credit card amount is lower, the same or even slightly higher than the RRSP withdrawal tax, then you’ll want to go the debt route and keep your RRSP intact.
If you do go the debt route, then you need to formulate a plan to get it paid off as soon as possible. Click on over here and pick your debt repayment poison.
The exception for pulling money out of your RRSP is if you are doing so to buy your first home. The Canadian government has a program called the Home-Buyer’s Plan that allows you to withdraw money from your RRSP and not have to pay the standard withholding tax. You have to repay the amount over the next 15 years, but that means you don’t lose the contribution room, so the only downside is lost investment growth.
Have you ever withdrawn money from your RRSP to pay off debt? And if so, do you think it was the right decision?