Should You Dip Into Your RRSP to Pay Back Debt?

There are few questions in the world of personal financial planning that are more hotly debated than this one: is it better to pay off current debts first, or save for retirement?

This question deals with the allocation of your money upon receiving it - either putting it towards your RRSP and retirement accounts, or towards mortgage or credit card repayment. Beyond this question of how to distribute earned income, a related question deserves attention too: should you ever withdraw funds from your RRSP to repay your current debts?

Canadian consumer debt has been increasing in recent years and is expected to continue doing so in upcoming years.  Among the many factors contributing to Canada’s high levels of consumer debt, the culture of immediate gratification that we live in and the increased accessibility to credit are two major underlying factors. This culture of immediate gratification not only leads people to take on increased levels of debt quicker in an attempt to satisfy unquenchable desires for more, but it also motivates people to repay debts faster, as well. Undeniably, you feel good when you pay off large lump sums of debt. While paying off debt quickly is a good financial decision that will save you money in the long run, it is important to recognize that using a large chunk of your retirement savings to pay off a large debt will not teach you good budgeting habits. In fact, it has the ability to severely harm your future financial security.

With increased levels of debt, how can we begin to manage debt repayment? Moreover, should we ever dip into our RRSP and other retirement accounts to pull ourselves out of debt?

Here’s what happens when you withdraw money early from your RRSP to pay off current debts:
 

You have to pay withholding tax

One of the main incentives for individuals to avoid dipping into their retirement savings is the withholding tax hit that they upon early withdrawal. For the first $5,000 that you withdraw early, you are going to pay 10% on the amount withdrawn. On amounts between $5,000 and $15,000, you’ll be paying 20% on your withdrawn funds. On anything above $15,000, you will be subject to pay 30% in addition to the principal amount withdrawn.
For example, if you want to take $12,000 out of your RRSP account to pay off a large outstanding credit card bill, you actually would be paying $14,400 for that debt repayment. That’s an additional $2,400 that you are throwing away to pay off that debt.

Further, if you do withdraw a lump sum of cash from your retirement account, you are required to report that money as taxable income and may be subject to paying more taxes.
 

You aren’t just taxed once, you’re taxed twice

In addition to paying the withholding tax at the time of withdrawal (as described above), you’ll also be taxed when the season rolls around, as well. The funds that you withdraw from your RRSP are treated as taxable income, meaning you will be responsible for paying taxes on every dollar withdrawn. Further, if the withdrawn money pushes you in to a higher income bracket, you will also be subject to pay greater tax on all of your income.  It’s safe to say that this double taxation is one of the consequences associated with early RRSP withdrawal that hurts the most.
 

You lose RRSP contribution room

If you withdraw money early, you cannot recontribute that money back into your RRSP. This means your contributions can never achieve their maximum potential because your RRSP ceiling is lowered.
If you are in desperate need of additional funds, evaluate potential alternative sources of income from other investment vehicles that won’t result in such severe tax consequences. For example, not only are withdrawals from TFSAs tax-free, but unlike early RRSP withdrawals, you also get that contribution room back the following year.
 

You miss out on free money

By ‘free money’, I really mean interest income. By withdrawing early, you miss out on the opportunity for interest to grow on a greater principal amount. With average rates of return on RRSPs and other retirement accounts typically falling between 5-8%, you will be missing out on a significant chunk of money over the years. This additional interest income can prove to be an impactful supplement to the contributions you’ve made to your retirement savings and may be the difference between a hard-pressed retirement and a comfortable, financially secure one.  
 

Situations when early RRSP withdrawals may be acceptable

At this point, you should be thinking twice if you were considering withdrawing money from your RRSP to pay down debt. Knowing the disadvantages, then, is there ever a situation where it may be acceptable to withdraw money from your RRSP early in order to pay down some of your current debt?

Here are a few situations to consider:

• If the interest saved on debt is greater than the tax paid on the RRSP withdrawal (both the tax paid at time of withdrawal and income tax) and the future interest income that would be earned on the lump sum, then withdrawing from your RRSP may be an option. In order for this to be the case, the interest rate attached to your debt would have to be incredibly high.

• If you have been saving a substantial amount of money for an extended period of time and are in a situation where you may have too much money in your RRSPs (not a bad problem to have), you can also consider using RRSP funds to pay off debt. Since income from RRSP withdrawals are taxed, if you have an enormous amount of money in your RRSP account, it isn’t really necessary to shelter it if your tax burden at retirement will be greater than or equal to what it is now.

• If you experience a significant increase in your expected retirement income, early RRSP withdrawal to pay off current debts could also make sense. For example, if your spouse dies, the money that was held in their RRSP or RRIF account may be transferred to you if you are the designated beneficiary. This large influx of cash into your retirement accounts would result in an increase in your future income and thus, a greater tax burden, as well. Similar to above, if the tax burden of your income at time of retirement is greater than the tax burden and interest lost from early withdrawal, it could be acceptable to withdraw money from your RRSP early to pay off current, high interest debts.

 
In short, there are very few circumstances in which you should withdraw from your RRSPs early. The double tax hit you will experience, along with your inability to replace withdrawn funds and the future investment income you will miss out on, demonstrates the negative consequences that are associated with early withdrawal.

If you are in a situation where you have already taken money out of your RRSP, speak with a financial planner about how you can maximize current investments and future contributions to recoup some of the damages. By making a personal commitment to not touching your retirement savings accounts, you are setting future-self up to enjoy the golden years in the way you always envisioned.