The Consequences of Withdrawing RRSP Money Early

What happens when you withdraw money from your RRSP early?

Early withdrawals from RRSPs have three major costs:

1. You’ll miss out on the advantages of compound interest

An RRSP works best with long-term, steady contributions. That way, your savings grow because the interest you earn also earns interest. The interest on that interest earns interest, and so on. This is called compounding.

When you take money out of your RRSP early, you lose the opportunity to earn money while it's invested. Remember, you’re not taxed on money growing in your RRSP until you take it out.

2. You'll have to pay tax on your RRSP withdrawals

If you take money from your RRSP, the government will charge a withholding tax. The amount you pay depends on the amount you withdraw and where you live.

• Taking $5,000, means the withholding tax rate is 10%.

• Withdrawing between $5,001 and $15,000 means the withholding tax rate is 20%.

• Removing more than $15,000 means the withholding tax rate rises to 30%.

Note that these tax rates apply everywhere in Canada except Quebec. In Quebec, the federal rates are lower, but provincial tax rates apply in addition to the federal withdrawal rate.

In Quebec, upon withdrawal, your financial institution will deduct taxes (federal and provincial) that range between 21% and 31%.

• For a withdrawal of less than $5,000, deductions are around 21%. By withdrawing $5,000, after a $1,050 deduction, you will only have $3,950 left to pay off your debts.

• For a withdrawal between $5,001 and $15,000, deductions are around 26%. For a withdrawal of $15,000, $3,900 will be deducted. That means you’ll have $11,100 deposited into your account.

• For withdrawals greater than $15,000, deductions are around 31%. If you withdraw $16,000, $4,960 will be deducted, meaning you will have $11,040 at your disposal.

*Rates may vary and are provided for illustration purposes.

But the taxes don’t end there. Your taxable income will include the RRSP withdrawal for the year. So, if your marginal tax rate* is higher than the withholding tax rate, you’ll pay extra on your withdrawal.

(*The marginal tax rate is the amount of additional tax paid for every additional dollar earned as income.)

And withdrawals from a spousal RRSP can carry additional risks as well. Let’s say you’re making ongoing contributions to a spousal RRSP and your spouse withdraws funds. Depending on the timing, all or a portion of the withdrawal will be included in your taxable income and not your spouse’s. This may result in an additional tax implication if you’re in a higher tax bracket than your spouse. So, it’s best to check with an advisor before making a withdrawal, to see how it may affect you.

3. You’ll permanently lose RRSP contribution room

You can only put so much into your RRSP. So, once you take money out, you can’t replace the amount you had previously put into your registered savings plan. This reduces the potential value of your RRSP when you’re ready to retire.

What can you do if you need emergency funds?

Simply put, experts advise not to take money from your RRSP before you retire. It’s best to explore other options before you touch your RRSP.

So, if a financial emergency arises and you need cash, there are some alternatives to consider:

• You can take money out of your tax-free savings account (TFSA). A TFSA is a good place to keep an emergency fund. Why? Because you can put back any money you take out the following year. (But be sure to repay your TFSA promptly, to minimize the loss of investment growth.)

• You can withdraw funds from non-registered assets. This might include guaranteed investment certificates (GICs),  segregated funds or savings bonds. If you have these assets, consider using them before touching your RRSP. Unlike withdrawing funds from an RRSP, withdrawing funds from these investments won’t increase your taxable income. (Although, you’ll give up the potential investment earnings).

If you need to tap your non-registered savings, you may need to consider a few other factors:

• Had you planned to use these funds for retirement? Then you may have to adjust your retirement savings plan. Make some tweaks to ensure that you’ll still have enough funds to afford the lifestyle you want.

• Has a financial emergency left you looking for an ongoing source of cash? If so, start by re-evaluating your budget and temporarily reducing expenses you don’t need.