When it comes to debt, it is common for Canadians to believe that cashing our their Registered Retirement Savings Plans (RRSPs) and investments to pay off debt is a smart move. This is not necessarily the case. There are a number of reasons why using RRSP to pay off debt is not such a good idea. For instance, it can affect your retirement plans, leaving you with less time to fund your pension. In this article, we will explore using RRSP to pay off debt and share all you need to know before you act. We will also provide an overview of some other forms of debt relief so that you can make an informed decision on how to act based on your unique financial circumstances.
How does a RRSP work?
A Registered Retirement Savings Plan is a scheme that allows employees and self-employed Canadians to put aside pre-tax income. It enables your funds to increase without incurring tax payments until they are cashed out. RRSPs will grow depending on how much you contribute into your account. The purpose is primarily to save your funds until retirement, at which point you withdraw it. As you will likely be older and earning less (if anything), your tax rate is much likely to be lower than cashing out the funds at a younger age. Depending on your province, withdrawing a RRSP early could incur up to 30% in tax. There are a couple of exceptions to this rule which we will discuss later, although you must comply with the repayment terms.
Using RRSP to pay off debt – why is it not such a good idea?
There are a number of reasons why using RRSP to pay off debt may not be the best option for you to take. Here are some of the primary reasons why:
- Your retirement plans will face consequences. Without a RRSP, you will find yourself with less time than before to fund your pension to prepare for your retirement.
- You will lose out on interest payments. If you cash out your RRSP early, you will miss out on the opportunity to increase your retirement fund via the interest that comes from your plan’s compound interest. Depending on how much is in your RRSP, this is potentially a lot of money.
- You will need to pay income tax. As the funds in your RRSP are deducted from your annual income, it is not taxable provided it remains in the RRSP. If, however, you cash out your RRSP, this cash will be taxable, meaning you will have to pay tax when it comes to filing your income taxes.
- You may face a withholding tax. If you cash out your RRSP and use it towards anything other than purchasing a first home or for retirement, you will need to pay a withholding tax. This means a reduction in the amount you withdraw, which is less to go towards paying off your debts.
What is a good alternative to using RRSP to pay off debt?
If your debt is unmanageable, the first thing you should do is speak to a Licensed Insolvency Trustee. They are the only professionals in Canada legally able to file all forms of debt relief, and are therefore best placed to advise you on your financial circumstances. While cashing out your RRSP to pay off your overwhelming debt can seem like an easy solution, it may not be the best solution in the long term. Instead, getting to the root cause of your problem may be best. Licensed Insolvency Trustees can help you to file bankruptcy, which offers you a fresh financial future by eliminating your unsecured debts. This can clear your debt for you without having an impact on your long-term investments. A popular bankruptcy alternative is a consumer proposal. A consumer proposal is the process of putting forward an affordable repayment amount to your creditors. A Licensed Insolvency Trustee will support you in proposing this figure, and will negotiate with your creditors on your behalf. It can reduce your debt by up to 80% while allowing you to keep your assets, and at Spergel we have an acceptance rate of 99% on any consumer proposals we file. Most creditors are likely to accept a consumer proposal over a bankruptcy, as they are likely to gain more money back. In line with the Bankruptcy and Insolvency Act, any contributions to your RRSP made in the last year before filing either of these methods of debt relief are protected. Both these forms of debt relief also help you on the journey to rebuilding your credit score. This means more financial opportunities for you in the future, while cashing in your RRSP to cover your debt can have a damaging effect on your finances longer term.
Should you use your assets to pay off debt?
A better way to make your debt repayments is to look at selling some of your assets. Perhaps you have some valuables lying around the house that you no longer use or need. Maybe you have an old car lying around, or some antiques or jewellery that you no longer wear. In this instance, it makes sense to sell it and use the money you gain to pay off your debt. The same could be said for any investment accounts you may have other than an RRSP. In fact the interest rate on your debt could be higher than that of your investment accounts, in which case it makes sense to cash them in to repay your debt.
When should you use your RRSP?
Ideally, you will only need to use your RRSP for its intended purpose – funding your retirement when you are in old age. That said, sometimes there are occasions where you may need cash to fund something more pressing in which case you may ‘borrow’ the funds. This is possible in a couple of instances. Firstly, you can cash in your RRSP funds to pay for your first home. You are able to withdraw up to $35,000 from your RRSP to use towards a down payment for your first home in line with the Home Buyers’ Plan. If you decide to do so, you are given a maximum of fifteen years to repay the sum which starts two years after you withdraw the cash. The other time you can cash out your RRSP without a hefty tax bill is in order to fund your education. You are allowed to in line with the Lifelong Learning Plan, which permits you to withdraw funds to pay off your school taxes or educational fees. You may take out up to $10,000 a year to a total of $20,000, and you have up to ten years to repay the amount you originally withdraw.
At Spergel, we can answer any questions you have on using RRSP to pay off debt. We can also review your financial circumstances and provide a recommendation on the best form of debt relief for you. Our experienced Licensed Insolvency Trustees have been helping Canadians gain debt relief for over thirty years. Book a free consultation today – you owe it to yourself.