Back in June, a BMO survey titled “Canadian Summer spending heats up” found 48 per cent of respondents admitted they would spend more than they should this summer.
It’s safe to assume they made good on it.
Overspending during the care-free days of summer is a familiar pattern, but when the bills roll in with autumn, many will turn to their registered retirement savings plan (RRSP) for relief.
A previous BMO survey found 38 per cent of Canadians dip into their RRSPs early for one reason or another.
If summer debt has you eyeing your RRSP savings, it’s important to know that early withdrawals could have staggering tax consequences, and there might be a better way to raise cash.
Tax consequences for RRSP withdrawals
If you are currently working full time, an RRSP withdrawal is probably the worst idea from a tax perspective. They are designed to allow contributions to grow tax-free in the investments of your choice until they are withdrawn in retirement - ideally at a lower marginal tax rate.
In addition to tax free growth, plan holders can benefit by contributing in years when their income is taxed at a higher marginal rate. If your highest marginal rate is 40 per cent, for example, you avoid paying a 40 per cent tax on your contribution the year it is made. If it is withdrawn at a 20 per cent marginal rate in retirement, you get big tax savings.
Early withdrawals not only deny the ability for that money to grow in investments over the years, but they will be taxed at a higher rate if your income is the same as it was when the contribution was made. That’s because the amount that is withdrawn is added to that year’s income. In other words, a contribution that resulted in a 40 per cent tax savings could be taxed at over 40 per cent.
It gets worse. Any RRSP withdrawal made by a plan holder under 65 years old is subject to an immediate withholding tax as high as 30 per cent. The maximum withholding tax applies to withdrawals over $15,000. It’s smaller for lower amounts and for residents of Quebec.
If an early RRSP withdrawal pushes your marginal tax rate over thirty per cent, you will owe more than the 30 per cent withholding tax when tax time comes around in the spring.
One more thing; once you make an early RRSP withdrawal, you lose that allowable contribution room if you are looking for a tax shelter in future, higher income, years.
When does it make sense to withdraw from an RRSP early?
If you have suffered a loss of income and your marginal tax rate is lower as a result, you must still pay the withholding tax on early RRSP withdrawals.
However, the final tax bill will be much lower because it will be taxed according to that year’s income regardless of your age. It just might be the lifeline you need to pay off your summer debt.
You can also avoid any tax if the funds are used to purchase a first home or go back to school (provided the funds are returned within a certain period of time).
Tax-free cash from a TFSA
A tax free savings account (TFSA) withdrawal is probably a better idea if you want quick cash to pay down debt. They are designed for short term savings.
TFSA contributions cannot be deducted from your income like RRSPs but withdrawals, and any returns they generate, are never taxed. There are contribution limits, so be sure to keep track.
Like an RRSP, you can hold a wide range of investments in a TFSA but if you expect to make early withdrawals, avoid investments that require longer term commitments.
Borrowing to pay down high-interest debt
If you choose to postpone your summer debt and pay the minimum amount on your credit card, interest on the balance can be as high as 30 per cent.
Even borrowing from consumer lines of credit can generate interest rates in the upper teens.
The rapid rise in interest rates over the past few years can make borrowing to pay for summer flings extremely costly and could lead to a lifetime of regret.
If you own a home, however, one short-term solution could involve paying down high interest debt with a low interest home equity line of credit (HELOC). HELOCs normally have the lowest rates because they are secured against the equity in your home.
HELOC interest rates are in a more manageable seven per cent range but can still add up as the balance compounds over time.
There are online debt calculators available that can help put the true cost of borrowing in perspective.
