Early withdrawal from your RRSP? - 02.11.2011

Weigh the costs

Early withdrawals from RRSPs have three major costs:

  • #1 – Withdrawals are taxable

When you withdraw funds from your RRSP they are immediately subject to withholding tax. By law, the withholding taxes are as follows: $5,000 or less, 10 per cent will be withheld; if you withdraw between $5,001 up to and including $15,000, 20 per cent will be withheld; and if you withdraw over $15,000, 30 per cent will be withheld (the combined federal and provincial rates are 21 per cent 30 per cent, and 35 per cent for residents of Quebec). This means that if you need $10,000, you’ll have to withdraw $12,500.

The amount that you withdraw will also be included in your taxable income for the year. If your marginal tax rate is larger than the withholding rate (which it usually is) you will owe additional taxes when you file your income tax return. Calculate your marginal tax rate.

Withdrawals from a spousal RRSP can carry additional risks. If you are making ongoing contributions to a spousal RRSP your withdrawals may be subject to attribution rules. Depending on the timing, all or a portion of the withdrawal will be included in your taxable income and not your spouse’s. This may result in an additional tax implication for your family if you are in a higher tax bracket than your spouse.

  • #2 – Loss of tax-sheltered compounding

When you withdraw funds from an RRSP, you lose one of the main benefits – the tax-sheltered compounding of earnings. Your 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 your savings.

For example, A 35 year old earning $30,000. Annual contributions to her RRSP are $3,600.

Her current account balance is $30,000. She decides to take out $5,000 to pay off her credit card bill.  Assumed rate of return is 7%.

Her account balance at age 65 would have been $592,231.

Her account balance at age 65 will now be $508,019

The cost of the $5,000 withdrawal is $84,212 from her future retirement account.

Roughly $350 of monthly income in retirement.

Calculate the impact of an early withdrawal for yourself

  • #3 – Permanent loss of contribution room

When you withdraw funds from an RRSP, you permanently lose the contribution room that you originally used to make your deposit. While you can continue making your maximum contribution to your RRSP in the future, you are not allowed to re-contribute the amount you withdrew. This reduces the potential value of your RRSP at retirement.

There are several other factors to considerations. Timing of the withdrawal, potential early withdrawal fees, and borrowing costs to name a few.

So what’s the alternative? Short of having accessible funds for these types of emergencies and opportunities, it may be beneficial to consider borrowing money instead.