Although financial advisors repeatedly lecture Canadians about the pitfalls of dipping into their RRSP accounts, recent studies reveal that many seem to be ignoring the advice.
A recent poll from Scotiabank found that about one-third of RRSP holders (36 per cent) reported they took money out of their RRSP account in 2012, up from 23 per cent back in 2005. As well, the average amount Canadians withdrew in 2012 was $24,531, more than double what they cashed out in 2005 ($10,716)
"Obviously, the goal is not to withdraw. You put the money in when you're in a high tax bracket, and it grows and accumulates," said Drew Abbott, vice president, TD Waterhouse Private Investment Advice. "The year you turn 71, you take it out, ideally at a lower margin tax bracket. That's the basic premise."
But people do withdraw from their RRSP account before the age of 71, and when they do, they have to pay a withholding tax on that cash at the time of withdrawal — and potentially also when they file their income tax.
"The concern we have is that people raid RRSPs for emergencies, and that can come back to haunt them in a number of ways," said Jamie Golombek, managing director of tax and estate planning for CIBC Private Wealth Management.
Not only is the money taxable, but, as Golombek points out, the money withdrawn reduces the amount you can contribute to RRSPs in the future, and unlike a tax-free savings account, that so-called contribution room is lost forever.
Still, people continue to withdraw. Golombek himself noted in a 2011 report for CIBC that "cash-strapped Canadians seem to be accessing funds in their RRSPs pre-retirement at an alarming rate."
The report found that 1.9 million Canadians withdrew $9.3 billion from their RRSPs in 2008.
There are a number of reasons why someone might dip into their RRSP account before retirement:
To buy a home: Not all withdrawals from an RRSP account are taxed. The federal government allows first-time home buyers to withdraw up to $25,000 from their RRSP without a penalty through the Homebuyers' Plan. Indeed, according to the Scotiabank poll, buying a first home was the No. 1 reason for withdrawing money from an RRSP.
But the money must be paid back to the RRSP account over a 15 year period, with participants required to repay a certain amount each year — generally 1/15 of the total amount withdrawn — if they don't want the withdrawn amount applied to their income.
However, writing in his blog The Blunt Bean Counter, Mark Goodfield, managing partner of Toronto-based Cunningham LLP, warned that in his experience, many people don't make the required annual payment, meaning it becomes taxable income.
Continuing education: The government also allows for a maximum $20,000 withdrawal for education at an accredited college or university under its Lifelong Learning Plan. Like with the Homebuyers' Plan, the RRSP amounts must be paid back, but in this case, over a 10-year period.
"Most people would attend post-secondary education at age 17, 18, 19, at which point they wouldn't have anything in their RRSP to withdraw," Golombek said. "But it's really good for people who want to go back to school to withdraw, [people who are] maybe between jobs — transitioning — and want to go on to an advanced degree."
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Golombek said a number of his MBA students at the Schulich School of Business at York University, where he teaches a course, said they have taken advantage of the plan.
He said the idea behind the homebuyers' and continuing education RRSP withdrawal plans is based on the premise "that you're financing a home that will grow in value or you're financing your education, which should hopefully lead to great earning power over one's lifetime."
Paying off debt: Some people feel they have no other choice but to dip into their RRSPs to provide some financial relief from their mounting debt. The Scotiabank poll found that paying off debt was the second-most popular reason to withdraw from an RRSP.
In some cases, it might be a smart financial move to use RRSPs to get rid of some of that debt if people are paying credit card interest rates approaching 20 per cent or higher, Golombek said.
But Goodfield said that strategy should be used with caution.
"Everybody wants Canadians to be out of debt and pay down debt," he said. "The problem is if you take it out of an RRSP and you're an average Canadian and your tax rate is 35 per cent, and you take $10,000 out of your RRSP, that's costing you $3 500 or even higher. So, now, you only have $6,500 to pay down the debt.
"I can't say I would never tell anybody to do that, but it's a bit of a costly way to pay down the debt."
Living expenses, vacation: The poll also found that 14 per cent of Canadians took money out of their RRSPs to cover day-to-day living expenses, and six per cent took money out to pay for a vacation.
"To me, I think that's crazy," Goodfield said, adding that that's just people "wanting instant gratification."
"My first thought would be before you're pulling from your RRSP, do a really detailed look at your budget and see what we can cut off. I don't want to hamper your lifestyle so you're not living and enjoying your lifestyle, but there's a lot of fat in most people's spending."
Laid off, out of work, divorce: A sudden or major change in someone's life, like losing a job, may also trigger an RRSP withdrawal.
"The theory being that at that point, they are at a very low tax bracket, so therefore, when they take the money out, they'll pay little if any tax on the RRSP withdrawal. [That] would make some sense," Golombek said.
As well, a divorce can place financial pressures on people who are suddenly living as a single person and no longer able to share costs and reap the tax benefits of splitting income, for example.
"I've seen clients cash in their RRSPs trying to get their life on an even keel cash flow-wise until they can get caught up," Goodfield said.
Covering the gap between retirement and RRIF payments: Both Abbott and Goodfield said many of their clients who cash out their RRSPs do so around and past the age of retirement and before they turn 71, the age at which they are legally required to terminate their RRSP.
"Where we see it is people coming up to the age of 71," Abbott said. "If people hadn't been working for 10 to 15 years and maybe ran out of their non-registered [funds] and have to start drawing on [their RRSP] early," Abbott said.
At this point, someone's income source may not adequately cover daily expenses, forcing people to cash in some of their RRSPs.
"Let's say you retire at 60 or 65," Goodfield said. "Assuming you're not getting a massive pension and you're going to be living off your RRSP and your conversion to your RRIF [Registered Retirement Income Fund]
at age 71, a lot of people have gaps if they retire at age 60 or 65. So, what people typically tend to do there is that's when they might draw their RRSP down."