How RRSP Withdrawals Work

how are rrsp withdrawals taxed

by FrugalTrader on December 8, 2010

The common trend in email questions these days regards paying down debt but considering an RRSP withdrawal to pay it down. As I’ve done an analysis on withdrawing from an RRSP to pay down credit card debt. I thought that it may be a good time to discuss the fine print of withdrawing from an RRSP.

In my opinion, for those still in working years, I’m not a big fan of withdrawing from an RRSP.  There are three major reasons for this, high taxation, the loss the contribution room, and the loss of years of tax free compounding.

RRSP Withdrawal Taxation

Withdrawals from an RRSP account are added to income for the year which are then taxed at your marginal tax rate.  This isn’t so bad if other income is low for the year, like in retirement, or a sabbatical.   But if you already have a high paying job, the withdrawal will simply add to your existing income and face income tax.

Withholding Tax

To help pay for this year end tax, the RRSP withdrawals face an initial withholding tax. Note that the withholding tax applies to EACH withdrawal and not the total annual withdrawal.

  • 10% for the first $5,000 (5% in Quebec)
  • 20% from $5,001 to $15,000 (10% in Quebec)
  • 30% for >$15,000 (15% in Quebec)

40% marginal tax rate and $5,000 withdrawn would result in

an initial withholding tax of $500, in addition to $5,000 added to reported income for the year. Providing that the extra income doesn’t result in a tax bracket jump, $5,000 x 40% – $500 = $1,500 owed at tax time.

Different Scenarios:

Withdrawals under the RRSP Home Buyers Plan (HBP), or the LifeLong Learning Plan (LLP) do not face income tax provided that they are paid back on schedule.  What about Spousal RRSP withdrawals?  For the details, check out this article on How Spousal RRSPs Work .

RRSP Contribution Room and Loss of Tax Free Compound Interest

As mentioned, once an investor withdraws from an RRSP, they lose that contribution room forever.  Unlike a TFSA where the contribution room is never lost.  While most Canadians never use all of their contribution room, it may be an issue for those who fully take advantage of the RRSP.  In addition, the earlier the investor withdraws from the RRSP, the more significant the damage as he/she is foregoing years of tax free compound interest.

Altogether, I believe that RRSP withdrawals should wait until close or during retirement when income is likely to be lower and the effects of losing contribution room and compound growth is reduced.  Have you seriously considered withdrawing from your RRSP?  If so, what was the reason?

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Source: www.milliondollarjourney.com

Category: Taxes

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