A Registered Retirement Savings Plan (RRSP) is a Canadian retirement savings system for employees and the self-employed.
Normally, an amount is placed in an RRSP and it grows tax-free until the withdrawal is made and then it is taxed at the marginal rate. Also note that having money in an RRSP is never the assurance of a comfortable retirement, it is only the assurance that the funds will compound, tax-free, as long as they are not withdrawn.
Again, the benefits of saving cannot be overemphasized, especially in this part of the world. We have the sole responsibility to structure our income to ensure that a substantial amount is saved for retirement.
How much savings do you have available to meet spontaneous needs and emergencies?
I’m sure you’ve probably heard the phrase “…saving for the future,” but it’s unlikely you’ve heard “…saving for retirement.” You may look at old people in your neighborhood and think that they are doing very well because they have well-off children.
While this may be true, it’s also possible that they had (or still have) a savings plan when they were much younger. The one they strictly followed and whose rules they respected.
Types of Registered Retirement Savings Plans (RRSP)
RRSPs are established by one or two people who are either partners or related in any way, including spouses.
There are many RRSPs which you’ve probably heard of, but here are a few:
1. Individual RRSP: This type is created by a single person who acts as both account holder/operator and funder.
2. Spousal (or couple) RRSP: This type provides for a single spouse and a tax advantage for both spouses. The spouse who earns the most income (usually referred to as the high-income spouse) is considered the spousal contributor since they contribute funds to the RRSP on behalf of their spouse (the account holder). Retirement income is of course shared equally, which allows for a lower marginal tax rate.
3. Group (or team) RRSP: This type of retirement plan works a little differently from the first two in that it is established by an employer on behalf of its employees. The investment in this account is mainly salary deductions and could also be incentives and arrears of income. It is managed by an investment manager and allows contributors to benefit from tax savings.
4. Jointly managed RRSP: This type of RRSP is not very common, but it is another effective type of RRSP. This option was essential for the good of SMEs. Now, small business employees, employers and self-employed Canadians can adequately plan for their retirement.
You will agree with me that accumulating consistent incoming funds, no matter how small, over a period of time can result in a massive return on investment.
Instead, these savings plans not only earn a lot when you invest over a long period of time, but they also generate significant returns if no withdrawals are made from the account. But what happens in the event of early withdrawals?
Penalties for early withdrawal from your RRSP
Tax is paid on withdrawal: I know I mentioned earlier that RRSP funds are tax-free, but you might be interested to know that when you withdraw from your RRSP, you would have to pay withholding tax fees that could have easily been avoided if you had not withdrawn. Withdrawals of up to $5,000 are subject to a 10% withholding tax rate.
Withdrawals between $5,001 and $15,000 are subject to a 20% withholding tax rate. Finally, withdrawals over $15,000 are subject to a 30% withholding tax rate. In areas where provincial tax rates apply above federal tax withholding.
For example in Quebec, these tax rates do not apply. Of course, be aware that when you withdraw money from your RRSP, you will have to report the entire amount as earnings in the year of withdrawal and this policy would result in a hefty tax bill.
The consequences are higher for withdrawals from a spousal RRSP. This is because if you contribute to the account and your spouse withdraws funds, 100% (or perhaps less) of the withdrawal will be added to your taxable income in your partner’s place. This would ultimately lead to more expenses and tax implications for your family.
I recommend that you clearly communicate these consequences to your spouse and that you both agree to refrain from any withdrawals. If it is an emergency and withdrawal is unavoidable, check with your financial advisor before making a withdrawal.
Confiscation of tax-sheltered composition
One of the advantages of the RRSP is above all to avoid the capitalization of income tax. So what good is the savings plan when the real goal is defeated?
When you withdraw early from your RRSP, no matter how small, due to the accumulation effect, you could end up with much less than you would have had if you had not made the withdrawal.
RRSP vs. RRSP TFSA
So if you need emergency funds at any time, I recommend withdrawing money from your Tax-Free Savings Account (TFSA). This is a relatively flexible account, in that you can return any money you withdraw in the near future.
Forfeiture of contribution rights: Would you like to lose the contribution rights with which you have always used to make your deposit? Cruel, right?
Well, that’s what happens when you withdraw from your RRSP. Not only would you lose it permanently, but you would also not be allowed to re-contribute the same amount you withdrew. Even if you can still make your maximum contribution in the future, it will never make up for the loss in value of your investment in retirement.
So like I said earlier, if you really need to make an emergency withdrawal, there are a few other accounts you can access without consequences.
One of them is your TFSA and others include investments like guaranteed investment certificates (GICs), savings bonds and segregated funds. These options should be explored before even considering your RRSP, as withdrawing funds from it would not increase your taxable income, you may simply risk losing potential investment income.
How to withdraw an RRSP and avoid tax penalties?
You know there are two sides to every coin, right? Well, there are also two sides to these policies! You can actually withdraw from your RRSP whenever you want without incurring tax penalties. Did you say how? Here’s how:
1. Get that house: This solution is commonly called the Home Buyers’ Plan (HBP). If you and your spouse have not owed a house in the last five years, this could well be a way for you to escape the tax penalties associated with withdrawing from your RRSP. This plan allows you and your spouse to withdraw up to $25,000 from each of your RRSPs to buy or build a house. Please note that this withdrawal is more like a loan as you are both expected to repay the amount within 15 years. The good news is that there is no interest payment on this amount.
2. Get that education: For some of you, education is one of the last things on your mind. Your high school diploma and/or college degree are pretty much all you need. While for others, all it takes is adequate funding to return to school or even follow training. It doesn’t really matter which category you fall into.
What is Lifelong Learning Plan (LLP)
All that matters now is that you can make withdrawals from your RRSP for the purpose known as the Lifelong Learning Plan (LLP).
This plan allows you to make withdrawals of up to $10,000 each year for 4 years to finance your education or training expenses or those of your spouse or even your common-law partner.
Again, this money cannot be used to fund your own child and the total amount must not exceed $20,000 payable in full within 10 years.
You will receive an LLP notice from the CRA each year with your LLP balance, the payment that was made and the amount of your next LLP payment.
Reserves withdrawn from your RRSP under the Home Buyers’ Plan (RAP) or the Continuing Education Plan (REEP) are not legally taxable provided that the amounts are repaid in record time. The only downside here is the loss of several years of tax-sheltered compounding on your retirement savings as you work to repay the amount. So, the sooner you can repay, the less growth you will lose.
Withdrawal from a locked-in RRSP
The simplest way to avoid unnecessary withdrawals from your RRSP is to lock in the funds. These locked-in funds will only be released when you reach a certain age. This age scale is for you to determine for yourself, although most people use 71.
All locked-in funds will only be released (not in all provinces) in the event of severe financial hardship or shortened lifespan.
Conclusion
And there you have it, that was the detailed guide to Canadian RRSP withdrawal and how it works.
I’ve written a ton of articles about RRSPs on this blog comparing RRSP to TFSA, RRSP in general, Canadian taxes, etc. Check them out if you want to know more or something specific.
If you found this article helpful, share it on social media and help spread the word. Also, for any questions or suggestions you may have, please let me know in the comments below. Have a fantastic day!
