Time RRSP withdrawals with care

Taken from article by James Daw

 

Most Canadians who save and invest for the future are smart about taxes.

More than two-thirds of us own a principal residence. We will pay no income taxes on any increase in value. More than a third of us invest inside registered retirement savings plans. We will pay no tax on our savings or investment gains until late in life.

But some RRSP contributors make early withdrawals. Some are smarter than others in the use of their funds. Some pay a double penalty.
The first penalty comes from missing decades of tax-deferred investment returns.
The second penalty can be to enjoy a smaller income increase from a withdrawal than the decrease when you put money away.
If someone in the lowest tax bracket puts in $2,000, and gets $400 in tax returns, the net cost is $1,600.
Later, if the person withdraws $2,000, she could lose $400 to tax, plus anywhere from $400 to $1,000 in government benefits.

But what if your income is low when it comes time to make the annual payments to return those emergency or borrowed withdrawals to your RRSP?

Under the Home Buyers' and Life Long Learning plans, you will owe tax each year you miss the minimum payment to your RRSP. A low-income family may also face a reduction in Canada Child Tax Benefits, and various other tax credits.

There could be a situation where a person would receive $2,000 in tax refunds for placing $10,000 into an RRSP over five years, then lose $2,500 to $6,000 to a combination of taxes and reduced government benefits.

Later in life, it may make more sense for a low-income earner to withdraw RRSP funds year by year before reaching age 65. After that age, that person could lose up to $700 from each $1,000 withdrawal due to a combination of taxes and a reduction in payments under the Guaranteed Income Supplement to the Old Age Security pension.

The percentage loss due to a combination of taxes and benefit reductions is referred to as a person's effective marginal tax rate. It's a percentage that cannot be determined simply by using tax preparation software. The taxpayer or an adviser will also have to use various benefit calculators available on government websites.

Two researchers have used data from tax returns to study RRSP contributions and early withdrawals by a large cross-section of Quebeckers between the ages of 24 to 59 between 1998 and 2003.

About 35 per cent of the taxpayers studied (without their names or addresses being known) reported making contributions to an RRSP, while earning little income from non-registered investments. Only about 5 per cent or 40,000 of the RRSP contributors withdrew money during that period.
What surprised the researchers was that those who stood to lose the most money by making pre-retirement RRSP withdrawals were also the ones most likely to make a withdrawal.
“This may suggest the (RRSP) plan holders are either unaware of their effective marginal tax rate or are (so short of cash they are) willing to withdraw money at a very high cost,” write Amin Mawani of the Schulich School of Business at York University and Suzanne Paquette of the Faculty of Administrative Studies at Laval University.  “Regardless, holding precautionary savings in RRSPs may not be an optimal strategy for such taxpayers. This result has not been documented in prior literature.”
Mawani and Paquette also found that users of the Home Buyers' Plan are not as successful as non-users in using RRSP contributions and withdrawals to reduce the variability of their taxable incomes.
Their ground-breaking study has yet to be published, but Mawani discussed some of the findings at a recent national conference of the Retirement Planners Association of Canada.

He and Paquette note in their study that further research will be required to see if the frequency of bad withdrawal decisions declines as more low-income earners start to make use of Tax-Free Savings Accounts (TFSA), the new tax-sheltered savings plan that became available starting last year.

Investors who deposit up to $5,000 a year in a TFSA for themselves or a spouse will not receive a tax refund for their contributions. But they will never pay tax on investment earnings and will never see a reduction in government benefits due to a withdrawal.

A TFSA will be the new smart choice for investors when their incomes are low, or may be low in future.