With RRSP season behind us, many of us are now eagerly awaiting the tax refunds we expect to receive this spring thanks to the RRSP contributions made throughout 2018 and in the first two months of 2019. Yet as the year progresses, the focus on saving is for many, replaced by the temptation to dip into the RRSP account.
If you think that might apply to you, consider the following short-term and long-term impacts early RRSP withdrawals can have on your finances.
One of the many great features Canadians love about RRSPs is the ability to reduce our tax burden by making contributions. Essentially, RRSPs save us money in the short-term while allowing for more wealth creation in the long-term. Yet for those who choose to make early withdrawals, the penalty can be quite steep.
The first tax penalty is referred to as the “withholding tax”. This is the tax that that the RRSP provider must deduct from your withdrawal and pay to the government. The table below illustrates the structure of the tax:
This demonstrates that early RRSP withdrawals can be quite costly at the onset. If you were to withdraw $8,000 for instance, your withholding tax (assuming you are outside Quebec) would be 20%. This amounts to an instant loss of $1,600. But the tax penalties do not stop there.
Higher marginal tax rate
In addition to the withholding tax, making early RRSP withdrawals can also result in you paying higher income tax. This is because the amount you withdraw is added to your earned income for the year and could push you to a higher tax bracket. And even if you remain in the same tax bracket, your income tax will inevitably be higher due to an increased proportion of your income being placed in your top bracket.
To offer an example, let’s say you earned a salary of $55,000 in 2018 and you chose to withdraw $8,000 from your RRSP that year. Assuming you were in Ontario, your income tax bill would rise by $772. And this of course does not include the withholding tax. In total, you would pay $2,372 more in taxes for making an $8,000 withdrawal, leaving you with only $5,627. If your withdrawal was higher, the tax penalty could be even steeper should you move to a higher bracket.*
Higher taxes are not the only penalty you can expect when you make early RRSP withdrawals. Virtually all financial institutions that provide RRSPs charge fees for processing withdrawals. These can range anywhere $50 to $150. This may not seem like much if you are making a large one-time withdrawal in the thousands. However, if you make multiple small withdrawals throughout the year, those fees can add up and offer another strong incentive against early withdrawals.
No compound growth
In addition to these hefty short-term losses, withdrawing money from your RRSP prematurely will also result in you losing out on the potential for significant compound growth over time. An RRSP is a great wealth building tool because it allows your savings to grow tax sheltered for a prolonged period of time. So every dollar that you contribute today will mean more savings awaiting you in retirement. By the same token, every dollar you withdraw early means lost growth potential and a smaller nest egg in retirement.
Going back to the example of the $8,000 withdrawal, your net gain of $5,627 pales in comparison to the savings you could have generated in 30 years had you not made the withdrawal. Assuming average net returns of 6%, that $8,000 could have ballooned to $45,947.93 after 30 years of tax-sheltered compound growth. This is a stark reminder of the impact early withdrawals could have on our nest eggs in retirement.
Early RRSP withdrawals come with a hefty price tag that can impact you not only in the short-term, but in the long-term as well. If you were thinking about dipping into your RRSP account this year, please do reflect on all the factors such as tax implications, withdrawal fees, and loss of long-term growth. In most cases, you will find that the short-term gain is simply not worth it.
* Note that tax-free withdrawals are possible only through the Home Buyer’s Plan (HBP) or Lifelong Learning Plan (LLP) whereby you would not be liable to pay a higher income tax or a withholding tax.
Open Access is a discretionary manager of group retirement plans. Being a fiduciary, we are legally and structurally bound to act in the best interests, and only the best interests, of our clients. This means no proprietary products, no conflicts of interest, and no hidden fees.