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What are the cons to withdrawing RRSP savings of $25,000 to pay off some unexpected bills I have incurred? —Anonymous
Ahh, the unexpected bills.
Anonymous, I’ll give you my initial thoughts first, and then I’ll review the cons of withdrawing from your registered retirement savings plan (RRSP) to pay off unexpected bills.
Assuming you’ve incurred the debt yourself and you’re not desperate—and I mean really desperate—don’t pay your bills with an RRSP withdrawal.
You acquired the debt on your own, so I recommend figuring out a way to pay it off without cashing in investments or consolidating loans.
When unexpected bills arrive, cash flow issues are normally the underlying culprit; either not enough income or too much spending.
What can you do to increase your income or reduce your spending so you can pay off your bills?
Withdrawing from your RRSP may seem like the easy way out. Paying off a debt by cashing in an RRSP or consolidating loans is just a temporary fix, and it starts a cycle. Look to your cashflow to find the solution, and in the long term you will be much better off.
Think about what you are giving up by withdrawing $25,000 from your RRSP. As you asked, Anonymous, here are the cons.
It’s not just the $25,000 you’re losing, but the future growth of the $25,000.
At age 30, with 35 years of compounding to age 65, your $25,000 will grow to $192,152 at 6% and $510,349 at 9%.
Play with this calculator to see what happens when you change the rates of return and time horizons.
I know you may think your plan is to start saving again once you pay off the bills, and in five years you’ll have the $25,000 again. If you do that, then in 30 years the $25,000 will grow to $143,587 at 6% and $331,692 at 9%.
Of course, that is assuming you deal with your cash flow issue, actually save the $25,000, and then never cash it in again to pay off another round of unexpected bills.
Know that RRSP withdrawals are fully taxable and that $25,000 will be added to your income. The benefit of RRSPs is that the money isn’t counted as income for the tax year that you make your deposit, and you make withdrawals when your income is much lower, say when you’re retired.
So, if you earn $75,000 this year, the additional $25,000 from your RRSP will take your taxable income to $100,000, which will likely push you into a higher next tax bracket.
In addition, RRSP withdrawals are subject to withholding tax. The financial institution holding your account withholds money from you and sends it to Ottawa as a prepayment of your annual tax.
The amount withheld is based on the following withdrawal amounts:
This means a $25,000 RRSP withdrawal puts $17,500 in your bank account after withholding tax.
Is your debt $17,500 or is it $25,000?
Because if it is $25,000 you’ll have to withdraw $35,714 from your RRSP. And, if that puts you into a higher tax bracket, you may have to pay even more tax at tax time.
Now, I know, you might be thinking you will just draw the $25,000 out in $5,000 increments to minimize the withholding tax, and yes, that is something you may be able to do over time. But remember, come tax time it all gets sorted out and you will pay the proper amount of tax.
Anonymous, I know it is easy to withdraw the funds from your RRSP, but if you can resist the temptation and do the hard work of finding a way to pay off bills through your cash flow, you will be much better off.
Allan Norman, M.Sc., CFP, CIM, RWM, is a fee-only certified financial planner with Atlantis Financial Inc. and a fully licensed investment advisor with Aligned Capital Partners Inc. He can be reached at atlantisfinancial.ca or firstname.lastname@example.org.