Many Canadians overspend in summer, but tapping into RRSPs early could lead to significant tax penalties
A June survey by BMO titled “Canadian Summer Spending Heats Up” revealed that 48 percent of respondents admitted they would likely overspend during the summer, according to BNN Bloomberg.
As the carefree days of summer come to an end, many Canadians may find themselves facing bills and considering tapping into their registered retirement savings plans (RRSPs) to manage their debt.
However, early RRSP withdrawals can have significant tax consequences, and there may be better alternatives to raising the necessary funds.
For those working full-time, withdrawing from an RRSP can be a costly mistake from a tax perspective. RRSPs are designed to allow contributions to grow tax-free until they are withdrawn in retirement, ideally at a lower marginal tax rate.
Contributions made during years of higher income can result in substantial tax savings, as they are taxed at a lower rate upon withdrawal in retirement.
However, early withdrawals not only reduce the potential for long-term investment growth but can also be taxed at a higher rate if your income remains consistent with when the contribution was made.
The withdrawn amount is added to that year's income, potentially resulting in a higher tax rate than the initial savings.
Additionally, any RRSP withdrawal made by plan holders under 65 years old is subject to an immediate withholding tax, which can be as high as 30 percent for withdrawals over $15,000.
This withholding tax can lead to an even higher tax burden if the withdrawal pushes your marginal tax rate above 30 percent.
Furthermore, once an early RRSP withdrawal is made, the allowable contribution room is permanently lost, reducing future opportunities for tax sheltering.
If you have experienced a loss of income, making an early RRSP withdrawal may be more manageable, as the final tax bill will be lower due to the reduced marginal tax rate. While you must still pay the withholding tax, the withdrawal may provide the necessary funds to pay off summer debt.
Additionally, tax can be avoided entirely if the funds are used for a first home purchase or education, provided the money is returned within the specified time frame.
A better option for quick cash to pay down debt might be a tax-free savings account (TFSA) withdrawal. TFSAs are designed for short-term savings, and while contributions cannot be deducted from income, withdrawals and any returns generated are never taxed.
It is essential to track contribution limits, but a TFSA offers flexibility and tax-free access to funds when needed.
For those who choose to delay paying off summer debt and only pay the minimum on credit cards, the interest rates can be as high as 30 percent. Borrowing from consumer lines of credit can also lead to high-interest costs, particularly given the recent rise in interest rates.
One potential solution for homeowners is using a home equity line of credit (HELOC) to pay down high-interest debt. HELOCs generally offer lower interest rates, around seven percent, as they are secured against the equity in your home.
However, it is essential to consider the long-term cost of borrowing, as interest can compound over time.
Online debt calculators are available to help put the true cost of borrowing into perspective, allowing individuals to make informed decisions about managing their debt.
