Sometimes, you end up in a position in which you want to access the money in your RRSP before you retire. One of those situations might be a desire to return to school. The Lifelong Learning Plan, allows you to withdraw a limited amount of money from your RRSP for educational purposes.
But what if you need to withdraw more money from your RRSP to go back to school? What if you want to supplement a maternity leave with money that is in your RRSP? Or, in the case of a job loss, you might also need to pull money out of your RRSP. Sometimes, your RRSP is your only emergency recourse.
In all three of these examples, your income will be lower than when you were working full time. You may have no income at all. Not only can an RRSP provide some much needed income in these situations, there could be a tax savings as well.
Paying Taxes on RRSP Withdrawals
When you withdraw money from your RRSP, you are going to have to pay taxes on that money. You received a tax benefit upon contributing, but now it's time to pay the government its cut. But, even if you have to withdraw and pay taxes, you might not have a huge problem.
As an example, if you have an income of $60,000 in Alberta, the marginal tax rate would be 30.5%. If you had made $10,000 in RRSP contributions that year, the tax refund would total $3,050.
Now say you wanted to go back to school or you lost your job. Maybe your income so far for the year is $20,000. If you need to withdraw that $10,000 from your RRSP, it would be taxable income at a tax rate of 25%, or $2,500. In this example you would have saved $550 in tax, and more importantly, allowed yourself to go back to school or survive a job loss.
If your income for the year is at $0 then you wouldn’t pay any tax on the withdrawal since it is less than your basic personal amount. You would, however, be subject to the withholding tax by banks, but you would get this amount back as a tax refund if your income remained that low for the entire year.
Drawbacks to Withdrawing Early from your RRSP
However, there are a few negatives to withdrawing from your RRSP before retirement. Most of the drawbacks have to do with opportunity cost. First of all, you will not get this contribution room back. Once it's gone, it's gone. Additionally, you are giving up the potential growth of the investment. You can't ever replace the work that capital would have done to earn a return over the years that it is now missing from your RRSP.
In certain circumstances, though, it makes sense to withdraw from the RRSP anyway. If you need the money now, you might as well see the tax benefit, and smooth your cash flow, than go into debt and wind up paying a lot in interest.