Using Your Nest Egg Early May Cost You

A Statistics Canada study indicates that more Canadians are cashing in their RRSP savings long before they reach retirement.

The money tucked away in your Retirement Savings Plan can be a tempting source of cash.  But think twice before withdrawing money from your retirement nest egg.  The amount you withdraw is considered income for that year and taxed accordingly.

Unless the withdrawal is made under the Home Buyers’ Plan or the Lifelong Learning Plan, you’ll immediately be hit with a hefty withholding tax, which may not cover all the tax payable.  Over the long term the cost of dipping into your RRSP early is even higher.

Trying to save on interest costs

Early withdrawals from your RRSP have hidden costs that can do long term damage to your retirement plan.  Consider this example:

Jason has diligently contributed to his RRSP every month and now has a sizable investment of $100,000.  He wants to buy a new car and needs $25,000.

Related: Is An RRSP Loan Necessary?

He can take out a loan, but he doesn’t want to pay the loan interest.  On the other hand he can use some of his retirement savings.  After all, he thinks he still has lots of time to save before he’ll need the money for retirement.  What’s the best option?

If Jason takes out a $25,000 loan at an annual rate of 7.5 % over 5 years, he’ll pay about $5,060 in interest costs.

If he taps into his RRSP to buy the car, he’ll actually have to withdraw $35,715 ($25,000 plus $10,715 to cover the mandatory 30% withholding tax).  This leaves his RRSP with $64,285.

Assuming the remaining balance grows at an annual compound rate of 4% over the next five years, his RRSP will increase in value to $78,212.

If he had left his plan intact, he would have $121,665.

In other words, the loan would cost about $5,000 in interest over five years while the RRSP withdrawal would cost him more than $43,000.

Related: Is Your Investment Loan Tax Deductible?

This doesn’t take into account any additional income tax that may apply when filing his tax return and, unlike with a TFSA, there is no opportunity to replace the borrowed money, as the contribution room will be lost.

Over 20 years, the cost of the lost compounding rises to $95,208.

Using government programs

An RRSP withdrawal made through the government’s Home Buyers’ and Lifelong Learning programs is not subject to withholding or income tax.  However, you have to repay the money in equal installments over the next 15 years.

If you miss a repayment, the amount will be added to that year’s income and taxed at your marginal tax rate.

Many will argue that higher education is an investment in greater future earnings and a house is an asset that will appreciate over time.

Also, borrowing from savings to purchase a house will allow you to make a more substantial down payment which enables you to avoid or reduce CMHC mortgage insurance fees and build the equity in your home faster.

Related: Why You Should Avoid Mortgage Life Insurance

However, the combination of a large withdrawal and a slow repayment schedule can have a significant impact on the growth of your retirement savings so think it through carefully.

While you don’t lose the contribution room, you will lose several years of tax-sheltered compound growth while you repay the loan.  The faster you’re able to pay the money back, the less growth you will lose.

Conclusion

Dipping into your RRSP for quick cash may seem tempting, but is it a wise move financially?

Over the long run it will likely prove to be very costly and will damage your retirement plan.  The withdrawal of even a small amount can have a substantial impact on the value of your savings and you will have to adjust your plan to ensure that you’ll still have sufficient funds to afford the lifestyle you want.

But what if you need funds?  If a financial emergency arises and you need cash, look at other alternatives first before making an RRSP withdrawal.

Consider your non-registered assets or TFSA.  A line of credit will offer a lower interest rate than a fixed term loan.

In most cases, though, it’s better to use the many different, more suitable, savings options available to you for both emergencies and future purchases.


16 Responses to Using Your Nest Egg Early May Cost You

  1. I learned this lesson the hard way. I needed $4,500 for a new roof, had no cash and didn’t want to run up my HELOC more than it already was. What could be easier than taking the money out of the RRSP? Bad decision.

    I needed $4,500 so I had to withdraw $5,000 because the bank automatically held or transfered $500 towards taxes to the government.

    Then I had to claim it as income on my tax return and I had no extra money to pay anything back in to the account so I had no tax deductions to offset the extra income. The result was no income tax refund for me from my 2011 and my accountant said that I was very lucky that I did not have to pay.

    Expensive lesson to learn.

  2. The idea that people who are in a precarious, illiquid financial position would go out and make a $25k purchase using RRSP money should be unbelievable. Welcome to Canada, the money-stupid country filled with financial geniuses.

  3. Pulling out of your retirement account is usually always a bad idea. The reason why they grow is because we leave the money in and continually add more. The withdraw fees are nasty, no matter if you live in Canada or the US.

  4. Withdrawal fees and even taxes aside, when you pull from your RRSP you’re taking away from your future. You’re taking money away from yourself, at a time when you’re going to need as much as possible and be bringing very little in. People need to remember why RRSPs are there in the first place, but that’s very very hard when you’re roof is caving in over your head.

  5. It’s a bad idea to pull out of an RRSP but reality is people will continue to do it. Friends of ours who were strapped for cash were left with no alternative and had to pull their money. Money in the future won’t help them if they can’t put a roof over their head now. I’ve had people email me saying they had no money in the bank or to pay their mortgage so they had to pull the money. Sometimes life gets in the way and the future will have to pay the cost. It’s unfortunate but it happens and that emergency savings fund is why I believe it’s important to set some cash aside but for some that might not be enough. Great post.

  6. Hi I have a Defined Benifite Pension PLan. I also am a year and a half away from retiring. We will have a 85000 dollar mortgage left on our house. I have 55000 in my RRSP. Is it wise for me to pull out some of this money to pay down the principle left on our mortgage. I will be
    making about 2300 per month after taxes based on my caculations. Thanks for a responce.

    • @Brian: Besides losing the future compounding on your RRSP, the main problem I see with withdrawing the funds is the tax you will have to pay. Don’t forget the withdrawal amount will be added to your income and, depending on your tax bracket, you may pay up to half of the amount in tax.

      Would you be able to increase your mortgage payments in the next 1 1/2 years to pay down your principal?
      Could you refinance to lower your interest rate or payment? Or consider a HELOC which offers more flexible payments?
      Will you be able to make the mortgage payments with your retirement income?

      These are some ideas to consider. Work out the numbers to see what would work best for you. Good luck.

  7. Drawback costs and also income taxes away, after you pull through your RRSP you’re taking away through your foreseeable future. You’re having money far from your self, at the same time while you’re should retain as much as possible and turn into getting very little inside. Folks should don’t forget why RRSPs is there to begin with, however that’s very very tough while you’re top is caving inside above your face.

  8. Some great advice Boomer. I had a friend that would occasionally dip in his nest egg before the economy started to get bad. He ran into trouble down the road.

    Needless to say this did damage his retirement plan. Anyhow thanks for the info.

    – James

  9. There are costs to early withdrawal, but your example is not calculating them correctly. If Jason does the RRSP withdrawal, after 5 years he has $78,212 in his RRSP AND an extra $30,060 outside it (assuming he has no extra contribution room left), since he didn’t make the loan payments. In the second situation, the $121k in the RRSP is still pre-tax, so to compare you need to have him pull out the $43,453 difference and pay 30% tax on it again (like you, I’m assuming his actual marginal tax rate is equal to the withholding tax, and I also assume it doesn’t change over the 5 years), which leaves him with $30,417 outside the RRSP and $78,212 inside… a whole $357 difference. This doesn’t take into account that he could have invested his loan payments outside the RRSP and made the same 4% return, which I haven’t calculated but I suspect would have him come out ahead (since the interest rate is higher on the loan than the growth in the RRSP).

    Always deduct taxes from the amount in your RRSP when tracking your net worth, because that’s still the government’s money – they just loaned it to you to invest for them. The withholding tax is not a penalty, just an estimate. If Jason’s tax rate after retirement is lower than 30%, then he would be better off with the extra money in his RRSP, but it’s not a slam dunk.

    The only guaranteed cost is the loss of contribution room that you mention. There’s also the high likelihood that he will spend some of the $30,060 that he’s not using to pay back the loan instead of investing it. Even then, he’s only down a few hundred bucks.

    • @Amanda: Thank you for your comments.

      It always surprises me that people will get hung up on figures and miss the point of the example. Clearly everyone has a different financial situation and habits.

      Maybe Jason doesn’t have the money to qualify for the loan payments.
      Maybe the loan payment amount would be absorbed into his monthly spending habits – hobbies, entertainment, buying the latest electronic gadgets, partying with friends.

      I have deliberately omitted the tax to be paid at retirement as it will vary depending on income and amount of withdrawal. Withholding tax is just a tax prepayment. You may receive some of it back but if you’re still working and make a large withdrawal that bounces you into the next tax bracket it will be costly.

      Finally, it makes no sense to withdraw from your RRSP to make a large purchase and then invest (what would be the loan payment) in a non registered investment. You’d have to get a really good return to make up for the taxes paid immediately and the longer term tax deferral.

      Sometimes there’s no choice but to withdraw from an RRSP, but if people considered all the consequences they may make different decisions.

  10. My wife and I are both retired. I have a defined benefit plan my wife does not have any employer pension plan. I split my pension with my wife so that we both get the pension tax credit. Over the years we contributed primarily to her RRSP. We both have the maximum in TFSA and will continue to invest in our TFSA.

    Should my wife begin to draw down her RRSP in order to get the funds for the TFSA before she begins to collect her CPP and OAS or should we leave her RRSP alone ? We have the cash to continue to make the maximum TFSA for the next number of years. My thinking is that this may be the best time to make some RRSP withdrawals because once she starts collecting government pensions then she will likely be in a higher bracket thus likely to pay more tax on RRSP withdrawals.

    • @Peter: Most financial advisors would recommend you defer taxes as long as possible until you are required to convert to a RRIF.

      I understand that you want to reduce taxes by having your wife start making withdrawals now while she has no other income and this, in turn, will reduce the amount of her RRSP so that when she converts it to a RRIF the minimum withdrawal will be less.

      What you have to consider is what she will do with the money. Paying off debt, gifting to your children and making large consumer purchases are worthwhile undertakings. However, if you choose to invest the money you must take into account how the investment returns will affect her future income. For example, Canadian dividends are tax advantaged, but the gross up could affect OAS payments and tax credits.

      Ernst and Young has calculators on their website that will give you the marginal tax rate on different investment options. You can try out different scenarios to see what will best suit you. Go to http://www.ey.com.

  11. Thanks for the responses. I should have added a little more detail initially – we have 0 debt, no mortgage, no credit card debt, no lines of credit and no car payments. I was just wondering about the wisdom of drawing down some of her RRSP to fund investment in TFSA at a time when she as limited income, moving the money laterally as it were. She will have to pay less tax on the withdrawal today than she will pay once she starts drawing OAS and CPP, unless I am missing something. Is this a reasonable approach?

    • @Peter: Sorry, you initially stated you have enough other funds to contribute to your TFSAs every year so I didn’t address that.

      She can withdraw from her RRSP now, pay the withholding tax (which will be refunded when she does her income tax) then contribute to her TFSA. (I am considering doing just that myself) . I recommend making the RRSP withdrawal at the end of the year, making the TFSA contribution at the start of the following year and filing the income tax return as soon as possible.

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