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Tapping your RRSP early has pros and cons

If you're short on cash in your bank account, but long on money inside your RRSP, don't despair. There are instances when you can borrow from your RRSP without taxes gobbling up your hard-earned savings.

Normally, when you withdraw money from an RRSP, you pay a withholding tax, which can be as high as 30 percent, depending on the amount you remove. Moreover, the amount you withdraw must be claimed as income in that year and is taxed at your marginal rate. So the amount you withdraw can evaporate quickly.

However, the federal government has two programs through which you can make tax-free withdrawals, provided you meet certain conditions and repay the money on time.

The Home Buyers' Plan helps first-time buyers buy or build a home, while the Lifelong Learning Plan lets people tap their RRSPs for educational purposes.

But before dipping into your hard-earned nest egg, "there are definitely some things people need to think about," says Lisa Ball, regional manager of Bank of Montreal Mutual Funds in Halifax, N.S.

When you remove money from your RRSP, it is no longer tax-sheltered and that must be weighed against the benefits of furthering your education or owning a home, says Ball. She says borrowers could find their "RRSP may be significantly less at retirement ... by withdrawing a large chunk now."

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The Home Buyers' Plan
Under the HBP, individuals may borrow as much as $20,000 from their RRSP. It can be in a single payment or a series of withdrawals throughout the year. If you are buying a home with someone else, he or she can also withdraw as much as $20,000 from his or her RRSP.

Each person must repay the entire amount within 15 years, at a rate of 1/15th per year, or $1,333 a year if you withdraw the maximum. Repayments start the second year after you make your withdrawal, so the $20,000 must be paid back within 17 years of its leaving your RRSP. If you fail to make the payments, that amount must be claimed as income on your tax return that year.

In order to qualify for the program, you must meet the following requirements:

  • you must be a Canadian resident
  • you cannot have previously owned a home for at least five years
  • you must enter into an agreement to buy or build a home, and
  • you must intend to occupy the home as your principal residence.

Bill Anderson, senior manager of financial planning and investment savings at Scotiabank in Toronto, says "the Home Buyers' Plan is getting more attention all the time, because it is a quick way to help you save for your down payment." But the money doesn't have to be used for that purpose. It can also be used to renovate the home you buy.

Calculating the long-term impact of removing $20,000 from your RRSP is no easy task, because it must be weighed against what you gain from buying a home, says Patricia Lovett-Reid, senior vice president at TD Waterhouse Canada in Toronto.

A $20,000 investment earning 7 percent in an RRSP would be worth $63,176 after 17 years. If you borrowed that amount and paid it back at the 1/15th per year rate of $1,333 a year, then at a 7 percent rate of return, it would be worth only $33,497, a difference of $29,679.

However, you must also consider whether your home will appreciate in value and by how much. If it increases substantially over that time, you could be further ahead.

As well, if the money was used as a down payment and allowed you to qualify for a cheaper mortgage, those savings must also be factored into the equation. For example, if you have less than 25 percent to put down on a home, then you must use a high-ratio mortgage, which can add thousands of dollars to your mortgage costs.

Lovett-Reid says borrowing from your RRSP is a great strategy if it helps you top up your down payment to qualify for a cheaper mortgage. For up-to-date mortgage rates, click here.

Before borrowing, Ball says home buyers have to be able to sustain the cash flow to repay the RRSP. Since the rules about withdrawing from and repaying your RRSP are intricate, you have to know what you're doing.

For example, some buyers might hold their down payments outside their RRSPs and then decide to put them into their RRSPs to get the tax refunds and then withdraw them shortly thereafter. It's a good idea, but, Bell warns, do your homework first: The Canada Customs and Revenue Agency has rules that could affect the deductibility of contributions made in the 89-day period prior to the withdrawal.

The Lifelong Learning Plan
Lovett-Reid says in today's rapidly changing world, workers change careers at least five times in their lifetimes. So, the Lifelong Learning Plan could be the ticket to finding a new job if you are laid off or need a change. According to the government, more than 41,000 Canadians have used the plan, withdrawing $275 million.

Under the LLP, you can withdraw as much as $20,000 from your RRSP to pay for full-time training or education at a qualified institution for you or your spouse. You cannot borrow from your RRSP to pay for your children's education.

To qualify you must:

  • be a Canadian resident
  • have an RRSP, and
  • be enrolled or accepted at a qualified educational institution as a full-time student. The program must last three consecutive months or more and require students to spend 10 hours or more per week on course work.

You can withdraw as much as $10,000 per calendar year and the money doesn't have to be spent on tuition. It can also be used for living expenses.

Armstrong says the LLP works in a fashion similar to the Home Buyers' Plan.The amount withdrawn must be repaid over 10 years at 1/10th per year, commencing the fifth year after your first withdrawal. BMO's Ball says if you fail to complete your courses, repayment commences automatically within 60 days.

Ball says it's difficult to determine the impact on your RRSP versus the benefits of a higher education. "Hopefully, you're not taking out too much," she says, adding that people usually pursue more education to get a higher income and therefore can contribute more to their retirement savings afterward.

Armstrong says the two plans are "tools that should be considered when looking at all your options. It's going to depend on your personal situation whether it fits your needs or not."

Jim Middlemiss is a freelance writer and lawyer based in Toronto, Ontario. He's a frequent contributor to National Post, Investment Executive and Wall Street and Technology.

-- Posted: Feb. 26, 2004
See Also
Banking on CPP?
52 Ways to Wreck your Retirement
Manage your money like a pension plan
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