How to borrow money from your RRSP without getting penalized
This article will explain the basics of RRSPs and early withdrawals. However, with all financial advice, we highly recommend that you speak to a professional when planning your personal finances.
A Registered Retirement Savings Plan (RRSP) is one of the most popular ways Canadians save for their retirement. In 2012, Canadians contributed a total of $35.7 billion to RRSPs.
Despite these funds being earmarked for retirement, a large number of Canadians continue to borrow from their RRSP for things other than their golden years. According to Statistics Canada, 1.82 million Canadians made an early withdrawal from their RRSP in 2012 (the most recent data available).
These early withdrawals could end up costing you, in the form of penalty taxes, but what do you do if you are in a financial emergency and need cash fast? Keep reading for tips on making early withdrawals from your RRSP and alternatives when you need cash fast.
An RRSP is an account registered with the Canadian government that offers certain tax benefits over other investment accounts.
Unlike a regular investment account, the contributions you make to your RRSP will not be taxed by the government until the funds are withdrawn down the road. Investments are able to grow and compound tax free. Because most people will be earning a lower income in their retirement, the taxes they pay on the funds withdrawn from an RRSP tend to be lower than during the peak earning years. Contributing to an RRSP also provides Canadians with tax credits on their annual income tax returns.
The tax benefits offered by RRSPs are the government’s way of encouraging Canadians to save for their retirement. RRSPs are a win for both future retirees and the feds – having lots of Canadians retire with healthy RRSPs lessens the burden on the government to provide for those in retirement.
“Government pensions are not enough to retire on,” said Bruce Barran, CPA, CA, a partner with Davis Martindale LLP. “You need to plan ahead for retirement and RRSPs are a good retirement savings vehicle.”
The government wants you to use your RRSP for retirement, not vacations and shopping sprees. To this end, provisions are in place that make it costly to make early withdrawals from your RRSP.
What happens if you make early withdrawals from your RRSP?
There are a few scenarios where this is permitted (including the Home Buyers’ Plan and Lifelong Learning Plan — more on this below), but beyond those, if you take out money from your RRSP early you’ll be penalized. Early withdrawals are subject to withholding taxes, meaning your financial institution will hold back the tax on the amount you withdraw and pay it to the government directly. The tax rate ranges from 10 to 30 per cent, depending on the amount you take out and where you live.
Withholding tax rates in Canada:
- 10% (5% in Quebec*) on amounts up to $5,000
- 20% (10% in Quebec*) on amounts over $5,000 up to including $15,000
- 30% (15% in Quebec*) on amounts over $15,000
*Residents of Quebec are also subject to a provincial withholding tax.
So let’s say you want to take $25,000 out of your RRSP to buy a new car or renovate your kitchen. The withholding tax applied would be $7,500 (30 per cent), so you’ll only end up with $17,500.
Additionally, when you make an early withdrawal from your RRSP, you lose the contribution room of those funds permanently. If you took out $10,000 early, you’ll never be allowed to re-contribute it, which reduces the potential value of your total RRSP at retirement.
How to borrow money from your RRSP without being penalized
There are two ways you can make an early withdrawal from your RRSP without getting dinged – through the Home Buyers’ Plan (HBP) and Lifelong Learning Plan (LLP).
The HBP allows you to borrow up to $25,000 from your RRSP to buy or build a home. To take advantage of the HBP you must be a first-time home buyer or haven’t owned a home in the last five years and you must repay the money within 15 years. For more information on the rules surrounding the Home Buyers’ Plan, consult the Canada Revenue Agency.
You can also borrow from your RRSP to finance education for yourself or spouse through the Lifelong Learning Plan. The LLP allows you to borrow up to $10,000 a year, up to a total of $20,000. To participate in the program the student must be enrolled on a full-time basis in a qualified program. You’ll have 10 years to pay back the money without being taxed.
The LLP cannot be used to finance your child’s education. For more on the rules surrounding the Lifelong Learning Plan, consult the Canada Revenue Agency.
Another scenario where it might make sense to borrow from your RRSP is if you are in a lower tax bracket than when you first contributed to your RRSP.
“If you don’t work for half the year, your tax bracket would be lower, so withdrawing wouldn’t be taxed as much,” said Gary Tymoschuk, VP of Operations at the Credit Counselling Society.
Alternatives to early RRSP withdrawals when you need cash
If you need money for something other than retirement, buying a home or funding your education, making an early withdrawal from your RRSP is not recommended.
“People should be very cautious about taking out of their RRSP – this is savings for your future. You may not have enough time before retirement to put the money back,” said Tymoschuk.
But what do you do when you find yourself in a dire situation after losing a job or falling ill, for example.
In a financial emergency, you may want to consider drawing from any non-registered assets you hold, such as savings bonds or guaranteed investment certificates (GICs). While these investments will take a hit, there’s no tax-sheltered benefit at risk.
Tax-free savings accounts (TFSAs) are another option. The registered accounts allow Canadians to save up to $5,500 per year and unused contribution room is carried forward to future years. TFSAs allow you to save money tax-free and withdrawals are also tax-free. Just be careful to follow the repayment rules closely, or you could be subject to a penalty tax.
One reason many Canadians dip into their RRSP is to pay off debt. Rather than borrowing from your RRSP, you could continue to contribute to it and use the refund for debt repayment.
If you have multiple debts, try securing a consolidated loan where you have just one payment at a much lower rate.
Another option to consider is a line of credit. A personal line of credit will allow you to borrow a certain amount of money, but unlike standard loans, you won’t be charged interest until you actually use the money. The interest rate on a line of credit is generally lower than most credit cards, so one strategy is to open a line of credit with a low interest rate to pay off your high-interest debts.
But be warned: Credit lines can be easily abused and if you are unable to curb your desire to charge things to your card, you could easily find yourself racking up more debt.
In 2011, David Chilton, author of The Wealthy Barber and The Wealthy Barber Returns, called credit lines “The worst thing that’s happening to Canadians in the last 20 years.” Once you’ve paid back the money borrowed from your line of credit that money becomes available to you again. Nonessential items like cars and vacations may prove too tempting for some. If you’re using a line of credit to pay off your credit cards, pay them off and cut up the cards to avoid the cycle of debt.
“When you need money desperately, people need to think really long and hard about what the best option is for them,” said Tymoschuk. If you are going to borrow, whether through a line of credit or home equity loan, he suggests comparing all your different options and looking for the lowest interest rate.
If you have to replace your roof, for example, look first at your savings accounts and things like GICs, said Tymoschuk. On the other extreme, avoid paying for it with a credit card. You need to ask yourself, “what are the costs of borrowing and what are the terms,” said Tymoschuk.
Note: This feature is for expository and informational purposes; it is not meant to be taken as personalized or expert financial advice.
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