One of the benefits of an RRSP is having the flexibility to withdraw some of the money before retirement. However, even though you can withdraw money from your RRSP prior to retirement, it doesn’t mean that you should. The action comes with a cost. That cost is a withholding tax.
RRSP withholding tax is the amount that the bank is required to submit to the CRA on your behalf. When you withdraw money from your RRSP, you are required to pay taxes, so the bank holds back a portion of your withdrawal and forwards it on.
Since withdrawn RRSPs are considered income in that year, the withholding tax is similar to your employer withholding a portion of your income to submit for your tax obligations.
How Much Withholding Tax Will You Pay?
The amount you pay in RRSP withholding tax is dependent on the amount of your withdrawal. There are three tiers, as follows:
- Withdrawals up to $5,000 will have a 10% (5% in Quebec) withholding tax.
- $5,001 to $15,000, 20% (10% in Quebec) withholding tax.
- $15,001 or more, 30% (15% in Quebec) withholding tax.
RRSP Withholding Tax For Non-Residents
Non-residents of Canada pay a withholding tax of 25%, except in places where that amount is reduced by treaty. In other words, living outside of Canada could cost you if you decide to withdraw your RRSPs.
Obviously there is a benefit to keeping your individual withdrawals to $5,000 or less. You will pay less in withholding tax. However, if you need more money, you may have no choice but to pay the higher amount in tax.
While you might think it’s beneficial to have access to the money inside your RRSP throughout the year, keep in mind that the withholding tax rate is separate from your marginal income tax rate.
The Impact Of An RRSP Withdrawal At Tax Time
In addition to the withholding tax paid, you will have to claim your RRSP withdrawal amount as income, come April 30th. For example, let’s say you withdraw $5000 and incur an RRSP withdrawal tax of 10%.
If your marginal tax rate for the year is 20%-50%, you could end up owing the government quite a bit more at tax time than the 10% you have paid so far.
The $5000 that you withdrew must be included in your overall income and will be taxed at your marginal rate.
To avoid this, you would need to be in a position where your overall income for the year was very, very low. More on this a bit later.
If you are withdrawing RRSPs for retirement, or any other time you are in need of income, you should know your marginal tax rate so that you will be prepared for the amount of tax you will still need to pay.
The website TaxTips has personal income tax rate tables which illustrate marginal tax rates, province by province, at all income levels.
The Opportunity Cost Of Withdrawing RRSPs
The impact of an RRSP withdrawal on your income tax situation isn’t the only cost associated with withdrawing RRSPs. You also have to consider the opportunity cost.
In other words, as soon as you withdraw funds from your RRSP, the money is no longer there, working on your behalf. You no longer have that capital in your account building your wealth. You can’t get that lost time back, and the interest you would have earned, even if you replace the capital at a later date.
Here’s a simple example, to illustrate the opportunity cost of a premature RRSP withdrawal:
Let’s say you withdraw $10,000 from an RRSP at age 45.
At a 20% withholding tax rate, you’ll receive a net amount of $8000. For simplicity’s sake, we’ll assume that your income tax situation is such that you have no other tax consequences related to the original $10,000 withdrawal, outside of the $2000 withholding tax.
Now, had you left that $10,000 growing in your RRSP until your retirement at age 62, you would have experienced an additional 17 years of tax-sheltered growth.
If we use an assumed rate of return of 5% annually, (reasonable for a broad-based equity investment), that $10,000 would be worth $22,920 by the time you retire at age 62.
In this scenario, your opportunity cost could be as much as $14,920, if you realized $8000 from your RRSP withdrawal at age 45.
This is why it’s so important to consider all of your options before you decide to withdraw from your RRSPs.
Depending on your situation, it might even make more financial sense to borrow money from a term reducing loan, if you can do so at a reasonable rate.
Either way, make sure you consult with a knowledgeable financial professional who can help you figure out the best way to go about making your withdrawals, and who can help you plan for your tax payments.
How To Avoid RRSP Withholding Tax
There are two common scenarios that allow you to avoid RRSP withholding tax. The first is by withdrawing funds under the First Time Home Buyers’ Plan, the other through the Lifelong Learning Plan.
Let’s take a quick look at each of these government programs:
The Lifelong Learning Plan (LLP)
The Lifelong Learning Plan is a federal government program that allows you to borrow a limited amount of money from your RRSP to pay for your post-secondary education.
The funds are withdrawn without triggering withholding tax, but they must be repaid into the RRSP over several years. When you make an LLP withdrawal, you also do not have to claim the amount as income at tax time.
The Home Buyers’ Plan (HBP)
The Home Buyers’ Plan is another popular government program that enables first-time home buyers to withdraw funds from their RRSP to go towards the down payment on the purchase of a home.
Similar to the Lifelong Learning Plan, there is no withholding tax collected at source on the withdrawal, and funds are not considered as taxable income.
However, funds withdrawn must be repaid into the RRSP over several years. If repayment is not made, the home buyer will be penalized by CRA.
With today’s costs of both housing and a post-secondary education being so high, these programs can be very valuable. Remember though, while they allow you to avoid the income tax on RRSP withdrawals, you will still incur an opportunity cost.
Withholding Tax and Low-Income Individuals
Every Canadian taxpayer receives a basic personal income tax credit. In 2018, the amount is $11,809, meaning that you won’t pay any federal tax on an income below that amount. Since the RRSP withholding tax is refundable on your tax return, like any other tax paid throughout the year, those with low income can get the withholding tax back.
If you make an RRSP withdrawal during a year when your annual income happens to be very low, you could receive up to the full amount of withholding tax back in the form of an income tax refund.
This might apply if you are a stay-at-home parent not earning income, you suffer a job loss, or are away from work for an extended period, say a personal or maternity leave.
If an RRSP withdrawal is necessary, a year in which you’re earning little to no income may provide the best opportunity to do so. As they say, timing is everything.
Summary
RRSPs are an important part of an effective retirement savings strategy, but making withdrawals at any stage can be costly. As such, it’s important to understand the impact an RRSP withdrawal will have on your personal financial situation, including how withholding tax is applied.
