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What to consider before making an early RRSP withdrawal

Canadians use Registered Retirement Savings Plans (RRSPs) to pay less income tax throughout their working career and as a way to save for retirement. 

RRSPs are tax-advantaged accounts that can be a vital tool for building a secure financial future. People typically contribute to their RRSPs with the intent of leaving that money in the fund to grow and generate interest until they retire, which reduces their taxable income and builds wealth for the future. 

However, unexpected events like the loss of employment, a divorce, or a family emergency can cause a person to consider withdrawing funds from their RRSP before they are ready to retire, or until they reach the age of 71. 

This decision can have a significant impact on a person’s long-term financial well-being. 

 

What is an RRSP?

An RRSP is a Registered Retirement Savings Plan that helps working people reduce their taxable income and save for retirement. Many types of investments can be made through an RRSP including stocks, mutual funds, and high-interest savings accounts.

Canadians can contribute up to 18% of their gross annual income into an RRSP, thereby reducing their taxable income by the amount of money contributed, allowing them to pay less tax.

What are the consequences of withdrawing from an RRSP before retirement?

It’s important to note that RRSPs are tax-deferred, not tax-free. 

This means that, unless you’re using the funds under the Home Buyers’ Plan (HBP) or the Lifelong Learning Plan (LLP), you will pay tax based on your current taxable rate at the time when the funds are withdrawn. 

If you withdraw funds from your RRSP before you retire, you will have to pay tax on those funds based on your current tax rate. If you make more money now than you did when you started contributing to your RRSPs, your current rate could be higher than it was when you made the original contribution. 

When you withdraw funds from your RRSP, your bank or financial institution will hold back a portion of those funds and make a tax payment to the federal government on your behalf. It’s important to be prepared for the government to request additional taxes when you file your tax return, as the bank is not responsible to ensure they withdraw the correct amount. 

 

When does it make sense to withdraw from an RRSP early?

The Canadian government has created two plans to make it easier for people to enjoy the tax benefits of RRSPs while also saving to purchase a home or pay for their post-secondary education. 

These plans are called the Home Buyers’ Plan (HBP) and the Lifelong Learning Plan (LLP). 

What is the Home Buyers’ Plan (HBP)? 

Under the Home Buyers’ Plan, a person can withdraw up to $35,000 from their RRSPs without penalty, if those funds are being used to buy or build a qualifying home for themselves or for a related person with a disability.

When someone withdraws funds via the HBA, they have up to 15 years to repay those funds into their RRSP, pooled registered pension plan (PRPP) or specified pension plan (SPP).

If the amount withdrawn is not repaid on time, the person will have to pay income tax on the amount still outstanding.

What is the Lifelong Learning Plan (LPP)?

Under the LLP, a person can withdraw up to $10,000 per year from their RRSPs without penalty (up to a maximum of $20,000 or four years), provided these funds are being used to finance full-time training or education for that person, their spouse, or common law partner. 

Financial institutions do not withhold tax on these amounts, and the funds must be repaid to the RRSP within 10 years. 

If the amount withdrawn is not repaid on time, the person will have to pay income tax on however much is still outstanding. 

 

How to reduce the tax hit from an early withdrawal?

By now you’ve gathered that withdrawing funds from your RRSP before you are ready to retire or purchase your first home is not a good idea. But let’s be realistic – unexpected events happen and sometimes we need a quick influx of cash. 

In those cases, what are the alternatives to making an early RRSP withdrawal? Here are three. 

  1. It's always a good idea to have three to six months of living expenses saved in a High-Interest Savings Account (HISA) that is easily accessible in the event of an emergency. 
  2. Just like you make regular contributions to your RRSPs, consider making regular contributions to an easily accessible Tax-Free Savings Account (TFSA). While these accounts won’t help you save money when tax time rolls around, they do allow you to forgo paying tax on any income generated by the interest in this account.
  3. If you’re a homeowner, consider taking out a Home Equity Line of Credit. This product allows homeowners to borrow money against the equity in their home. The beauty of HELOCs is that, while you may be approved for a high amount, you only pay interest on the amount you withdraw.

 

The bottom line

Early withdrawals from your RRSPs can create a hefty tax bill, and significantly reduce the amount of funds you’ll be able to access once you retire. Be sure to consider every option before you decide to make an early withdrawal from your RRSPs. 

 

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