As Canadians are facing economic uncertainty due to COVID-19, their concerns about household debt are paramount. A recent poll found that a significant number of respondents could only cover expenses by going into debt.
Yet, this is hardly the most ideal way of approaching hardship — especially since, when it’s time to pay that money back, interest rates may make it difficult to pay it all off. While this may be the only apparent solution for many people, if you have an RRSP account, you may be wondering whether taking money out of RRSP to pay debt is a good idea.
The Impact of Payment Deferrals and Cashing in Assets
Many Canadians were already facing high levels of debt before the current financial crisis. Even though banks have reduced their credit card interest rates, a high percentage of minimum payments consist of interest charges alone.
For those who have deferred their debt payments because of recent difficult circumstances, the interest is still growing and accumulating every day. So how can you pay off those high credit card balances and interest charges, and lift that overwhelming burden of debt hanging over your head?
One of the many options could be cashing in some of your financial assets. Though this would seem like a simple enough solution, let's consider how doing something like using RRSP to pay off debt would affect your tax situation.
How Does an RRSP Account Work?
A Registered Retirement Savings Plan (RRSP) allows employees and self-employed individuals in Canada to set aside pre-tax income. These funds continue to grow, tax-free, until they are withdrawn. How fast such an account grows depends on the amounts of your contributions and whether you have an investment portfolio.
A benefit of waiting until retirement to take out the cash is that the tax rate would likely be lower than if you withdraw the funds early. In fact, taking money out before you reach 71 years of age means your tax withholdings could range up to 30%, depending on your province.
There are exceptions to the tax penalties from early withdrawal including taking out up to $25,000 to buy a home, or up to $20,000 to pay for school. And for such exceptions to apply, you must comply with all of the repayment requirements.
All this information sounds great during ordinary circumstances, but desperate times call for desperate measures, and the COVID pandemic and its associated financial ramifications may push you to hold on to what’s available right now — and for you, that could very well be the money in your RRSP account.
Disadvantages of Cashing in an RRSP
Let’s look at possible scenarios for borrowing from your RRSP to pay debt (though you don’t “borrow” from the plan per se — you’re actually “cashing in” the plan), and the consequences you could face.
If you take out $10,000, approximately 20 percent or more is held for taxes, so you would only receive $8,000 or less. Therefore, if you need to pay off a $10,000 debt, you will need to withdraw at least $12,500.
It’s also possible that, when cashing in your RRSP to pay debt, the taxes held back may not be sufficient to cover your full tax bill, which means you could wind up paying even more when you file your tax return. For example, let's say you withdraw $20,000 from your RRSP. That $20,000 will be considered extra income, so you will need to pay the taxes on it when you file.
Now, let's say your taxable income was $40,000 for the year. The approximate rate in Ontario for your federal and provincial taxes combined could be about 20 percent, or $8,000. If you withdrew $20,000 from your RRSP, your income jumps to $60,000, moving you into a higher tax bracket where the combined tax rate would be an average of approximately 32 percent. This could result in a whopping $19,200 in taxes. So withdrawing $20,000 from your RRSP could ultimately result in you being on the hook for $11,200 more in taxes. Depending on the amount of the original debt, this additional tax burden could put you in a worse financial situation.
Something else you want to keep in mind is that cashing out your RRSP early may result in losing your deduction limit/contribution room permanently. This means you’d likely have to pay taxes of 1% every month on your future RRSP contributions that exceed your previous limit. So, taking money out of RRSP to pay debt isn’t always the best option.
Advantages of Cashing in an RRSP
On the other hand, taking money out of RRSP may be to your advantage if your income is low or if you are only taking out a small amount. If your income is low enough, or if the amount of money you are withdrawing from your RRSP is small enough, the additional income you are withdrawing from your RRSP might not make your total income jump to a higher tax bracket.
For example, if you earn $20,000 per year, your taxes could be about 20 percent (or $4,000). If you withdrew $5,000 from your RRSP, your income would be $25,000 and taxed at the same rate of 20 percent (or $5,000). So, although your taxes would seem to be $1,000 higher, they could actually become less after considering credits and other deductions.
A Note on Cashing In Qualified Investments in an RRSP
The Canada Revenue Agency (CRA) allows certain types of investments to be held in an RRSP. They are known as qualified investments and may include items like stocks, government bonds, mutual funds, cash, gold, silver, and shares in Canadian small businesses, to name a few.
While it may seem like you are diversifying your investments and that doing so provides you with additional sources of income, taking out this money early exposes you to the same types of penalties of withdrawing regular funds from your RRSP. So, at the end of the day, the only way to figure out whether doing so would be a sound idea depends on your specific circumstances and the advice of a financial professional.
Should I Cash in Non-RRSP Investments to Pay Off Debt?
If you have money in investments other than an RRSP, withdrawing money from them to pay off debt could be advantageous. Why? The interest rate on your debt is probably significantly higher than the rate of return on an investment.
For example, a Guaranteed Investment Certificate (GIC) might earn you an annual rate of return (or interest) of 2 percent, while the annual interest rate of the average credit card is around 19 percent. In other words, you will spend 17 percent more in interest than you will earn on your investment. At today's low interest rates, there is no doubt that you will be saving more money paying off the debt rather than holding a fixed income investment. Even in the case of an unsecured line of credit at 7 percent, you are likely paying more interest on that line of credit than you are earning interest from a fixed income investment. Although there may be taxes on these investments when they are cashed, the extra amount owed may not be all that significant.
Additional Potential Sources of Funds to Pay Off Debt
As you can see, whether you should use your RRSP to pay off debt during the COVID-19 pandemic depends on:
- Your income bracket
- How much you contribute to your RRSP
- Your investments
- Amount of debt
- Interest rate on that debt
If it turns out that it’s not a sound financial choice for you, you may start wondering about alternatives to using RRSP to pay debt. These alternatives may include:
Cashing in Equity Investments
For equity investments such as stocks, the return on your investment could be more than your debt charges. However, as we have recently seen, there is no guarantee on your rate of return, which could easily go down as quickly as it goes up. If the value of your investments has significantly decreased due to the recent market drop, you may be tempted to hold onto them until the market recovers.
Under normal circumstances, that would be sage advice for most investors. However, it might be wiser to sell off some of your investments to pay off your debt, as it is likely the return on your investment might currently be less than the interest rate you are paying on your debt. There may also be tax implications from the investment’s gains or losses when you cash it in.
For example, if the investment is sold at a loss, this can be claimed against future capital gains. It is important to discuss liquidating your equity investments with a tax professional before considering this as an option.
Using Tax-Free Savings to Pay Off Debt
When it comes to Tax-Free Savings Accounts (TFSAs), there may not be any major personal tax implications if you cash in some of the investment or make a withdrawal. However, if you have invested your limit for the year, you must wait until the following year to redeposit the amount you've withdrawn. As with fixed income and equity investments, the interest paid on any debt is likely going to be higher than the return on your investment. So again, you're better off paying down your debt than stockpiling your money in the bank.
What Is the Best Way to Pay Off My Debt?
As you can see, there are many options to repay your outstanding debt. Although it is wise to start planning now, be sure you have an idea of your current financial situation before moving forward with a plan like using RRSP to pay off debt.
A recent article in Maclean’s illustrates the serious debt problems Canadians are now facing due to COVID-19. Before you consider cashing in any of your investments, it's important to speak with a tax professional, such as an accountant or financial planner, to examine the pros and cons of each of the options regarding your particular situation.
What Are My Debt Repayment Options?
A good starting point would be to contact us, Credit Canada Debt Solutions, and book a free Debt Assessment to discuss your overall financial picture with a certified professional. The appointment is confidential and judgement-free.
One of our certified Credit Counsellors will review all of your debt repayment options, including our Debt Consolidation Program (DCP), and work with you to find the best solution that suits your needs. By implementing the right debt repayment plan wisely, you can achieve freedom from stress and worry and become happily debt-free.
