Should you borrow from your RRSP to pay down debt?
If you feel overwhelmed with debt but have a basket of riches in your RRSP, you need to think carefully before tapping into your retirement money to pay off debts.
Financial experts warn that dipping into your RRSP is a costly way to reduce your debt load and one that will have a negative impact on your long-term retirement goals.
It's a last resort strategy, says Colin Montgomery,
a financial adviser at Edward Jones, in Regina, and it should only
be used if you're facing bankruptcy or the loss of your home and
have exhausted all other avenues, such as negotiating a suitable
payment plan with creditors or refinancing your existing debt.
He says an RRSP shouldn't be viewed as a bank account ready to be accessed at a moment's notice. Employees wouldn't ask their boss for an advance on their pension to pay down their debt, he says, and the same thinking should apply to an RRSP.
"We tell everybody to treat their RRSP like a pension," says Montgomery. "The money is tied up for retirement, and that's what it should be used for."
Only two ways to borrow from RRSP
There are a couple of instances when you can borrow from your RRSP with minimal pain, but paying down debt isn't one of them.
For example, new homebuyers can borrow from an RRSP for a down payment, but they must pay it back within a certain time frame or face penalties. If you want to go back to school, you can also withdraw funds without penalties but must also pay them back.
In most other instances, when you remove money from your RRSP, it's treated as income. So, taxes become payable on it, and you lose the both the contribution room and the tax-free growth benefits those contributions generate.
Tania Slade, regional manager with BMO Mutual Funds, in Toronto, says it's the initial tax hit that makes withdrawals so unappealing. She says someone who earns $40,000 a year who wants to withdraw $30,000 from an RRSP would pay approximately $9,000 in tax, leaving him with only $21,000 to spend.
At a six percent return, that $30,000 would grow to $72,000 over 15 years, which could account for two years of living expenses in retirement.
You'll also need to replace that money. Assuming you take no more than 15 years to repay the borrowed funds, you could pay an extra $24,000 on top of the $30,000 simply to catch up to where you would have been if you had not removed the money. "That's huge," she says.
Adrian Mastracci, a fee-only investment adviser with
KCM Wealth Management, in Vancouver, says "the medicine tastes awful"
when taking money out of your RRSP to pay debt. "You can't put the
money back in. Every dollar you pull out is taxable," he says. If
you take money out, the contribution room is lost forever, and that
can make it hard to catch up later.
He says if you take it out in small increments, you can temporarily defer the tax pain, since withdrawals of less than $5,000 generate a 10 percent withholding tax. But at tax time, you will have to account for that income and come up with the money.
Address the root problem
Slade says another problem with tapping your RRSP is that it doesn't address the root problem that got you into debt in the first place. If your spending habits don't change, she says, taking money from your RRSP "is a short-term solution. You're going to wind up in trouble again."
So, what should you do? Slade suggests working with a professional financial adviser or credit counsellor to go over your situation and look at how you spend your disposable income.
One thing she looks at is mortgage payments. If you have an accelerated mortgage and are paying it faster than required, there might be some wiggle room to free up cash flow for your debts.
Mastracci adds it might also mean taking a consolidating loan and cutting up credit cards "Lending institutions have so many ways of lending you money these days, I am sure they can find you ways to lend money that are better than what you're doing right now."
Montgomery agrees that refinancing is the best option to pursue before you admit defeat and take money from your RRSP. It could be as simple as asking a credit card company for a better rate or switching to a cheaper card. For a $50 annual fee, you can see your rate drop from 18 to 12 percent. For current rates on low-rate credit cards, check out Bankrate.ca's credit card rate homepage.
"The best thing to do is talk to somebody who can run scenarios both ways for you to find out in the long run what's best," says Montgomery. "Try not to make those decisions based on the emotion that you would just like to be out of debt and not consider the impact five to 10 years down the road."
If you've exhausted those options and still stand to lose your home or go into bankruptcy, then you can consider using your retirement savings, but not before. "If you're in dire straits, then yeah, you've got to tap into your RRSP," says Slade.
Jim Middlemiss is a freelance
writer and lawyer based in Toronto. He's a frequent contributor to the National
Post, Investment Executive and Wall Street & Technology.