When you’re struggling with unaffordable debt, dipping into your Registered Retirement Savings Plan (RRSP) can be tempting. After all, It’s a quick fix: simply withdraw your money and wipe out your credit card balance or another loan that’s causing you grief.
However, in most cases, cashing in your RRSP to pay off debt is a bad idea. You risk triggering hefty tax consequences and sabotaging your future financial security. It’s a solution that often creates more problems than it solves in the long run.
In this article, we’ll explain why using money from your RRSP to pay off debt isn’t ideal. We’ll also explore exceptions to this rule and alternatives that can help you tackle your debts without sacrificing your retirement nest egg.
Reasons to avoid cashing out your RRSP to pay off debt
An annual RRSP study from the Bank of Montreal revealed that 34% of RRSP holders had withdrawn money from their accounts before reaching the age limit of 71. And 20% of respondents said they used the funds to pay off debt.
So, if it’s a popular strategy, does that make it a good idea? Not exactly. Here are some reasons why using your RRSP as a form of debt relief isn’t a smart move.
You’ll have to pay withholding tax
When you withdraw money from your RRSP, you won’t receive everything. By law, your financial institution must deduct a portion of the withdrawal for tax purposes. This amount is known as the withholding tax. It’s essentially a prepayment of the tax you’ll eventually pay when you file your tax return.
The amount of withholding tax you’ll pay depends on the size of your withdrawal. Here are the current withholding tax rates:
| Withdrawal Amount | Withholding Tax |
| Up to $5,000 | 10% |
| Over $5,000 and up to $15,000 | 20% |
| Over $15,000 | 30% |
Note: The rates differ for Quebec residents: 5%, 10%, and 15%, respectively.
Due to withholding taxes, you won’t be able to use the amount you were expecting to use to pay off your debts. For example, if you withdraw $10,000, you’ll receive only $8,000 ($10,000 x 80%).
You could face a higher tax bill
Any money that you withdraw from your RRSP is considered taxable income. As a result, you must report the full amount on your tax return in the year of withdrawal.
Depending on your current income, the addition of the RRSP withdrawal could push you into a higher tax bracket, saddling you with a higher tax bill. That means you may owe even more come tax time, above and beyond the initial withholding. And if you cannot afford to pay taxes you owe to the CRA, you could face unpleasant consequences.
Check out this RRSP withholding tax calculator to learn how much tax you could wind up paying based on your income, tax bracket, and withdrawal amount.
You’ll lose contribution room
Unlike a Tax-Free Savings Account (TFSA), an RRSP contribution room is not restored when you make a withdrawal. Once you withdraw the money, you can’t add it back in at a future date. The contribution room is gone forever, whether you take out $25 or $25,000. That’s a big setback if you’re hoping to rebuild your retirement savings in the future.
You’ll miss out on future earnings
The money in your RRSP grows tax-free, which allows it to compound quickly over time—but only if you leave it untouched. By taking money out early to pay off debt, you lose many years of tax-free interest and capital gains. Cash withdrawals from your RRSP will limit its potential growth, especially if you do it routinely.
You could endanger your retirement plan
Your RRSP is meant to support you in retirement, not to serve as an emergency fund. Withdrawing funds now can leave you short on cash later in life, especially if you don’t have an employer-sponsored pension or other savings.
Even a modest RRSP withdrawal could mean thousands of dollars less in retirement. For example, if you take out $5,000, that amount may have grown to be worth $20,000 in the future, depending on your RRSP’s annual earning rate. That means you’ve sacrificed $20,000 from your future retirement by using your RRSP to pay down debt.
Scenarios where taking money from your RRSP makes sense
Using money from your RRSP to clear debt is usually unwise. But there are some situations where it may be justified or even a strategic choice. Below are some examples where withdrawing from your RRSP may be worthwhile.
1. You want to buy a home and qualify for the Home Buyers Plan (HBP)
The Home Buyers’ Plan (HBP)enables first-time homebuyers to withdraw up to $60,000 from their Registered Retirement Savings Plan (RRSP) to contribute toward the purchase of a home.
Unlike a regular RRSP withdrawal, the money you cash out isn’t taxable. You must redeposit the full amount into your RRSP over 15 years. In other words, you’re “borrowing” from your RRSP to help pay for your home purchase.
By taking money from your RRSP under the HBP, you’re sacrificing investment growth. However, it can be shrewd to secure a mortgage and lower your cost of borrowing. Just ensure you’re financially prepared to make the annual repayments; otherwise, you’ll have to include the amount as part of your taxable income.
2. You need money to pay for your education
The Lifelong Learning Plan (LLP) allows individuals to withdraw up $10,000 per year (up to a maximum of $20,000) to pay for full-time post secondary or training.
Like the HBP, withdrawals under the program are not taxable. But to avoid tax penalties, you must redeposit these withdrawals into your RRSP over a 10-year period.
As with the HBP, you’re giving potentially lucrative tax-deferred growth by taking out funds from your RRSP. However, it could be a wise move if going back to school will significantly boost your future income.
3. You earn a low income or are unemployed
If you currently earn a low income or are unemployed, withdrawing money from your RRSP is a reasonable option. Your withdrawals are subject to a lower tax rate than if you were earning a high income, so you’ll face a smaller tax bill in April.
Still, cashing out a portion of your account will mean less money for your retirement, so ensure the sacrifice is worthwhile. For example, suppose you’re living paycheque to paycheck and need extra money to cover a mortgage payment. In that case, you may dip into your RRSP to avoid endangering your home.
Better solutions for paying off debt
There are more financially savvy ways to reduce your debt load without tapping into your RRSP. Here are a few options to explore.
Revise your budget
Review your expenses to determine if you’re overspending in specific areas. Often, minor adjustments—like cutting discretionary spending or negotiating household bills—can free up money you can put toward your debt while keeping your RRSP intact.
Withdraw funds from your TFSA
Unlike RRSPs, withdrawals from withdrawals from a Tax-Free Savings Account (TFSA) are not taxable. You also don’t lose your contribution room, so you’re free to deposit the amount withdrawn in the future. This flexibility and tax efficiency make a TFSA a better source of funds for paying off debt.
However, by withdrawing money from your TFSA, you’re giving up tax-advantaged growth. So avoid making it a habit and prioritize other solutions, like revising your budget, instead.
Consolidate your debt
Debt consolidation combines multiple high-interest debts into a single loan at a lower interest rate. It works well for unsecured debts, such as credit cards, payday loans, and lines of credit. The arrangement leaves you with one payment to make each month and can lower your interest, allowing you to save money and pay off your balance sooner.
There are many ways to consolidate your debt. Some popular methods involve debt consolidation loan, balance transfer credit cards, and home equity loans. However, if you have bad credit or earn a low income, you may be denied a debt consolidation.
Consider a consumer proposal or bankruptcy
A consumer proposal allows you to negotiate a legally binding debt settlement with your unsecured creditors. You could potentially reduce your debt by up to 80%, with the remainder payable over five years. In more serious debt situations, filing for bankruptcy might be the right path, which will eliminate 100% of your unsecured debts.
Another reason why a consumer proposal or bankruptcy is preferable is that your RRSP is safe from seizure by creditors. The only exception is money you contributed during the 12 months before your proposal or bankruptcy filing date. By filing a proposal or bankruptcy, you can keep your RRSP intact while lowering your debt burden.
Learn more about the differences between a consumer proposal and personal bankruptcy.
The bottom line on using your RRSP to pay off debt
Withdrawing your RRSP to pay off debt may seem like a quick fix. However, in most cases, the long-term consequences outweigh the short-term relief. The tax penalties and loss in asset growth can set you back financially and derail your retirement plans.
There are a few scenarios where tapping into your RRSP is warranted, such as using the Home Buyer’s Plan or if your income is exceptionally low. But even in those cases, it’s worth considering alternative options first. Budgeting adjustments, TFSA withdrawals, and formal debt relief programs, such as a consumer proposal, can help you manage your debt effectively with fewer negative repercussions.
If you’re unable to manage your debt payments, it may be time to speak with a Licensed Insolvency Trustee (LIT). An LIT can help you explore all your options to pay off debt without raiding your RRSP and putting your retirement plans at risk. Contact David Sklar & Associates today for a free, no-obligation consultation. No matter how dire your debt situation, there’s always a solution that can help you start fresh.
