Dale Jackson

Personal Finance Columnist, Payback Time

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It’s stunning how single impulsive financial actions can morph into crippling burdens later in life. Most of us know of someone who lived to regret letting their credit card payments slide, lost track of a mountain of “small” monthly payments for online services, or conveniently forgot to report income on their tax returns.
 
One financial regret to add to the pile could be withdrawing money from your registered retirement savings plan (RRSP) while you are still working full-time.
 
One of the Rs stands for retirement for a reason: RRSPs are designed to allow contributions to grow tax-free in the investments of your choice until they are withdrawn in retirement - ideally at a lower marginal tax rate.
 
In addition to tax-free growth, plan holders can benefit by contributing in years when their income is taxed at a higher marginal rate. If your highest marginal rate is 40 per cent, for example, you avoid paying a 40 per cent tax on your contribution the year it is made. If it is withdrawn at a 20 per cent marginal rate in retirement, you get huge tax savings.  
 
Early withdrawals not only deny the ability for that money to grow in investments over the years, but they could be taxed at a higher rate if your income is the same as it was when the contribution was made. That’s because the amount that is withdrawn is added to that year’s income. In other words, a contribution that resulted in a 40 per cent tax savings could be taxed at 50 per cent.    
 
It gets worse. Any RRSP withdrawal made by a plan holder under the age of 65 is subject to an immediate withholding tax as high as 30 per cent. The maximum withholding tax applies to withdrawals over $15,000. It’s smaller for lower amounts and residents of Quebec.
 
If an early RRSP withdrawal pushes your marginal tax rate over thirty per cent, you will owe more than the 30 per cent withholding tax come tax time.
 
One more thing. Once you make an early RRSP withdrawal, you lose that allowable contribution room if you are looking for a tax shelter in future, higher income, years.
 

When it makes sense to withdraw from an RRSP early

If you have suffered a loss of income and your marginal tax rate is lower as a result, you must still pay the withholding tax on early withdrawals. However, you will likely get money back at tax time.

Aside from the withholding tax, RRSP withdrawals are taxed according to that year’s income regardless of your age. It just might be the lifeline you need to get through tough times.
 
You can also avoid any tax if the funds are used to purchase a first home or go back to school (provided the funds are returned within a certain period of time).
 

Alternatives for cash in a crunch

If your income hasn’t changed and you need cash for an emergency, the experts say you should always have an emergency fund. That doesn’t happen in the real world and it doesn’t really make sense to have money sitting in cash when it could be generating returns.

Consider investing through a tax-free savings account (TFSA), which is designed for short-term savings. TFSA contributions can’t be deducted from your income like RRSPs; but withdrawals, and any returns they generate, are never taxed. There are contribution limits, so be sure to keep track.
 
Avoid borrowing at high interest rates, like credit card balances. Consumer loans from conventional banks usually have lower borrowing costs.
 
Better yet, if you own a home, you can use the equity in it to establish a secured line of credit and borrow at any time. Home equity lines of credit (HELOCs) usually provide the lowest interest rates because they are secured using the home as collateral.
 
Using your bank as a cash machine also has its drawbacks and using it too often without paying it back could end up becoming one of those crippling burdens later in life.