More Canadians are cashing in their RRSP savings long before they reach retirement.
According to a recent poll, over one-third (36%) reported they took money out of their RRSPs in 2012, up from 23% in 2005. The average amount they withdrew is also rising quickly: $24,531 in 2012, more than double what they cashed out in 2005 ($10,716).
Even though early withdrawals are increasingly common, is it a wise move financially? In most cases, the answer is no. Early withdrawals from RRSPs have hidden costs that can do long-term damage to your clients’ retirement plans.
Weigh the costs
Early withdrawals from RRSPs have 3 major costs:
1. Loss of tax-sheltered compounding
When clients withdraw funds from RRSPs, they lose one of the main benefits: the tax-sheltered compounding of earnings. Their RRSP earnings are sheltered from tax until withdrawal, and because of the effects of compounding, the withdrawal of even a relatively small amount can have a substantial impact on the long-term value of their savings.
For example, if a client withdraws $6,000 from an RRSP and earns a 7% return each year, after 25 years, that client will have over $32,000 less in the RRSP than if the client hadn’t made the withdrawal.
2. Withdrawals are taxable
Any withdrawals from an RRSP are immediately subject to withholding tax. How much? It depends on how much they withdraw:
|Withdrawal amount||Withholding tax rate in all
provinces, except Quebec
rate in Quebec
|Up to $5,000||10%||21%|
|Between $5,000 and $15,000||20%||26%|
|More than $15,000||30%||31%|
The taxes don’t end there. The amount of the withdrawal is included in the taxable income for the year, so if the marginal tax rate is higher than the withholding tax rate, they’ll have to pay additional tax at year-end on the funds they’ve withdrawn.
3. Permanent loss of contribution room
When clients withdraw funds from RRSPs, they permanently lose the contribution room that they originally used to make their deposit. While they can continue making their maximum contribution to their RRSPs in the future, they’re not allowed to re-contribute the amount they withdrew. This reduces the potential value of their RRSPs at retirement.
Exceptions to the rule
There are certain situations in which early withdrawals from RRSPs may provide benefits. Withdrawals to buy a home or finance education are treated differently than other early RRSP withdrawals.
The lifelong learning plan (LLP) allows clients to withdraw up to $10,000 per year for a 4-year period from their RRSPs (to a maximum of $20,000) to pay for the education of the client or spouse (not their child). Clients must repay the full amount within 10 years. The spouse may also use the RRSPs to participate in the plan, subject to the same limits.
The home buyers’ plan (HBP) allows a client and spouse to borrow up to $25,000 from each of their RRSPs to build or buy a home, provided that the client and spouse have not owned a home in the past 5 years. They must repay the amounts borrowed to their RRSPs within 15 years. However, this type of withdrawal is unlikely for retirement-age clients, as 77% of Canadians aged 50-691 already own a home.
Funds withdrawn under the HBP and the LLP are not taxable, provided that they repay them on time and meet all other conditions. While clients don’t lose the contribution room with these withdrawals, they’ll lose several years of tax-sheltered compounded growth on retirement savings while they repay the loan. The faster they’re able to pay the money back, the less growth they’ll lose.
What if clients need funds?
If a financial emergency arises and a client needs cash, there are some alternatives to consider before withdrawing retirement savings.
If clients have non-registered guaranteed investment certificates (GICs) or savings bonds, advise them to consider using these assets first. They won’t lose the tax-sheltering benefit, although they’ll give up the potential investment earnings. If they had earmarked these funds for retirement, they may have to adjust their retirement savings plan to ensure they’ll still have sufficient funds to afford the lifestyles they want.
If your clients are looking for an ongoing source of funds for a financial emergency, suggest that they consider diverting some of their money from an RRSP into a tax-free savings account (TFSA).
In most cases, your clients shouldn’t withdraw money from their RRSPs. Government restrictions encourage Canadians to leave their money in their RRSPs, so they can use it for the reason the government created these plans in the first place: receiving income when they actually retire.
1Trends in Homeownership by Age and Household Income. Statistics Canada, January 29, 2013.