Debt can feel like a burden that you’re carrying everywhere you go. When that weight is placed on your shoulders, you’ll want to be free of it as soon as possible. But, you don’t want to make rash decisions in your desperation to be free of this problem. Getting reckless about debt relief could lead to some big mistakes.
One of those mistakes could be turning to your RRSP or RRIF to tackle your outstanding debts. Read ahead to find out why that’s not the best conclusion to jump to right away and what alternatives could be much more useful.
RRSP 101:
An RRSP is a Registered Retirement Savings Plan. It’s a long-term investment account designed to help the user/users when they retire. After years of contributing to this fund, they are supposed to have a comfortable reserve of savings that they can rely on when they’re no longer in the workforce.
Why use an RRSP instead of using a pension plan through your workplace? A workplace pension would be more lucrative than a standard RRSP. But, the truth is that the majority of employees don’t get the opportunity to participate in this type of program. While some countries around the world have implemented mandatory employer pension programs, Canada has actually seen employee pension support go down in recent years. Research shows that only 37% of Canadians have a workplace pension plan to rely on — that’s just over a third of the population.
A workplace pension program may be more advantageous than a run-of-the-mill RRSP, but an RRSP is better than nothing at all. That’s why it’s often seen as an ideal money-saving solution for individuals who don’t have that support from their employers. It’s also an effective option for people who are freelancers or self-employed.
One of the benefits of an RRSP is that it can help you during tax season. Your annual contributions — up to a limited amount — are considered tax-exempt. These contributions are deducted from your annual income, allowing you to save more money while filing your taxes. It’s a very popular financial strategy.
While contributing to the account will be easy, taking funds out of it is not as consequence-free. The problem is that any RRSP withdrawal is considered part of your taxable income for that year. There are only two exceptions where the income won’t be taxed:
- If you use the money to buy or build a home for yourself
- If you use the money to pay for education as part of the Lifelong Learning Plan
Otherwise, taking funds out of your RRSP before you hit retirement will come at a personal cost.
RRIF 101:
Another important feature of an RRSP is that there is a time limit. Tax rules require you to withdraw from the plan by the time you reach the age of 71. Once you hit this age limit, you can remove the funds from your nest-egg in the form of cash — remember, this lump sum will be categorized as taxable income. You can buy an annuity to get consistent yearly payments. Or, you follow the most common response: turn that RRSP into an RRIF.
An RRIF is a Registered Retirement Income Fund. It’s a tax-deferred retirement plan that is fairly similar to an RRSP, but with a key difference: you cannot make financial contributions into your RRIF. It is designed for people during their retirement years, so the account does not consider input from paycheques or any other modes of income. It’s a fund that you’re supposed to rely on, not build.
Can an RRSP Help with Debt?
You are not the only one who has considered this quick-fix to resolve their outstanding debts. It’s more common than you’d think.
An annual RRSP study from the Bank of Montreal revealed that 34% of RRSP-holders had withdrawn money from the account before they reached the age limit of 71. While some of these respondents used their funds to support an early retirement and to purchase homes, others had used the funds to solve financial issues. According to the survey, 15% of these respondents used it to pay for emergencies. A whopping 24% used it to take care of their regular living expenses. And 20% of respondents used the funds to help pay off debt.
So, if it’s a popular strategy, does that make it a good idea? Not exactly. There are a few reasons why using your RRSP as a form of debt relief is not in your best interest.
Future Planning
It may not sound too important at the moment, but your RRSP will come in handy later on. You don’t want to rob yourself in the future to solve an issue in the present — especially if there are better ways to take care of your current situation. You may regret the fact that you touched the savings meant for your retirement when that time of your life draws closer.
An RRSP isn’t an emergency fund, and as a general rule of thumb, you shouldn’t treat it like one. It’s a savings account that is meant to support you later in life. It’s better not to touch it until you have to. Leave it alone and let it grow.
Withholding Tax
You’ll hear lots of financial experts warning you to avoid RRSP withdrawals for short-term debt problems. That is because your withdrawal will be taxed immediately when it’s taken out before the age limit. A withholding tax can reach up to 30% of the funds withdrawn. So, the money that you’re using to pay off your debt will be immediately trimmed down.
The taxes from your withdrawal will likely be bigger than the interest accumulating on your debts. As far as a debt-relief strategy goes, this one will likely hurt you more than it helps you.
Income Tax
Remember, an RRSP is not like a TFSA (Tax-Free Savings Account). Any amount that you take out will be considered taxable income. So, withdrawing funds from your RRSP may eliminate some of your debts in a short period, but you will deal with the consequences of this decision when tax season comes around. You’ll be solving a problem for a moment by creating a different problem for yourself in the span of a year.
Another issue with this solution is that taking out a substantial taxable sum could also be a quick way to jump deeper into debt. If you’re struggling with your finances or living from paycheque to paycheque, your withdrawal could be a debt trap. You don’t want to wipe away outstanding debt for credit cards or student loans and then find out that you can’t afford to make your payments to the Canada Revenue Agency.
So, What Can You Do Instead of Emptying Your RRSP?
You should look for a different solution than cashing out your RRSP to pay off your outstanding debts. You can see that it has consequences that could put you in more financial trouble. You can also see that the strategy sabotages your retirement savings. If you really want to rid yourself of this burden, you should look over these alternatives before you make any rash decisions.
Double-Check Your Finances
First things first, you should seriously assess your financial situation to determine if you’re insolvent or not. Insolvent means that you are unable to pay off your debts. Your income can’t cover your debt, especially after you’ve used it to pay for essentials like rent and groceries. Insolvency often pushes desperate people to debate whether they should pay for necessities or put money towards their debts. It’s a risky situation to be in.
Look over these financial danger signs to see if you’re dealing with insolvency. These are a few of the signs that should be ringing alarm bells:
- You have maxed out credit cards
- You have bounced multiple cheques
- You have taken out more than one payday loan
- You had one of your utilities cut off because of non-payments
- Your creditors have taken you to court over your debts
Or, you could go straight to David Sklar & Associates to talk to one of our licensed insolvency trustees. They will go over your personal finances to see where you stand and to see what types of intervention are ideal for resolving your debt problems.
Cinsider Credit Counselling
If they determine that you’re not officially insolvent, but you’re on the brink of reaching insolvency, you should sign up for credit counselling. This is an effective solution for anyone who is dealing with credit card debt. According to the Bank of Canada, Canadian credit card debt rates recently reached an all-time high, hitting a combined $79 billion in December 2019. As you can see, you’re not the only one who dreads seeing their credit card bills every month.
You can sign up for credit counselling at our licensed insolvency trustee firm. The sessions can focus on topics like debt management or budgeting — whatever will help you best achieve your financial goals. After these sessions, you could have the tools to better manage your money and handle your debts on your own.
Emptying your RRSP to tackle debt will come with consequences like extra taxes and reduced retirement savings. One of the other consequences that comes with this strategy is that it doesn’t teach you how to avoid debt. For instance, if poor credit use got you into the rough situation in the first place, you could easily end up in debt all over again. Learning how to properly manage your credit will make sure that you don’t repeat the same mistakes. Credit counselling isn’t a quick fix — it’s a long-term solution.
Consider a Consumer Proposal
If the trustee determines that you’re insolvent, then your next best solution is to file a consumer proposal. A consumer proposal is a legally binding agreement made between you and your creditors, accepting a lowered debt total. If the majority of creditors agree to your proposal, you have a maximum of five years to follow the set repayment plan. After the time limit is reached, you are finished with the repayments. Your debts to those creditors will be considered legally paid in full.
Why is a consumer proposal ideal in this situation? For one, it’s effective. It helps you tackle your outstanding debts to creditors by reducing the total amount. It puts obstacles like growing interest, late penalties and additional fees on hold, so the agreed total stays the same. It also puts collection methods like wage garnishment and collection calls on hold. Once the papers are signed, those stressors are off of the table.
Another reason why a consumer proposal is ideal in this situation is that your RRSP is safe. This debt relief option will not touch major assets like your house, your vehicle and your various investments, including your RRSP. The only exception is if you contributed to an RRSP in the 12 months before filing for a consumer proposal. In that case, your contributions may be clawed back — however, they will not be eliminated. Instead of emptying your RRSP to fix your debt problem, you can use a consumer proposal to tackle the debts and keep your account full at the same time.
And more importantly, a consumer proposal is often a better alternative to your other debt-relief options like personal bankruptcy. One of the motivations that causes people to avoid bankruptcy after claiming insolvency is that bankruptcy doesn’t protect their major assets, including portions of an RRSP. Essentially, the asset would be distributed among creditors. There are some exemptions from this: locked-in RRSPs through employment or RRSPs opened through a life insurance company.
Another alternative that people turn to when they’re determined to relieve their outstanding debts is a debt consolidation loan. Click here to find out what is debt consolidation and what are the risks that come with this type of loan.
Cashing out your RRSP sounds like a fast solution to a major problem like debt. But, when you take a closer look, you can see that this strategy is actually too good to be true. Emptying out your RRSP comes with some consequences that you may not even realize. Plus, there are solutions out there that can help you eliminate your outstanding debts and keep your RRSP safe at the same time.
