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Three Reasons You Shouldn't Rob Your RRSP to Pay Your Holiday Bills

01/12/2015 12:44 EST | Updated 03/14/2015 05:59 EDT

It's tempting, when times are tight, to dip into your retirement fund. It's a bad idea.

The brakes have just packed up on your car. Or planks are giving way on your back deck, and the whole thing needs replacing. Or perhaps you were overly generous during the holidays and now have a credit card statement hangover. Whatever the issue, you've got to spend some money, and cash flow isn't happening. But there's this pool of money you've put away for retirement, and maybe withdrawing some of that will cover the expenses.

It is tempting but my advice, in a word: Don't.

Raiding your registered retirement savings plan (RRSP) to help pay for short-term expenses shouldn't just be a last-ditch option. It shouldn't be an option at all. The impact on your retirement plan as well as your current tax situation goes far beyond any near-term benefit.

The Canadian government created the RRSP program in 1957. The goal was to allow Canadians to defer the tax they paid in their prime earning years to provide an income for retirement. In the meantime, interest on the RRSP investment would accumulate tax-free on a compound basis, providing a substantial nest-egg for seniors, especially those without a significant private pension in addition to the Canada Pension Plan (CPP) and Old Age Security (OAS).

It's that tax-free compounding factor that makes the whole RRSP notion work. And that's one of three reasons robbing your RRSP to deal with an urgent issue is simply a bad idea.

THE MAGIC OF GROWING TAX-FREE

If you invest in non-registered mutual funds, you have to report and pay tax on any income you earn. But an RRSP is a tax shelter that allows your investments to grow tax-free until you withdraw the funds in retirement. Because of the value of tax-free compounding, income earned within an RRSP will accumulate far more rapidly than income that is taxed.

If you remove money from that account, you're stripping tax-free compounding of some of its power. For example, you have $13,980 in your RRSP. Instead of letting it sit, you remove $5,000 for a trip to Vegas and some credit card debt, leaving a balance of $8,980. After 20 years you will have $16,220. That is (very basically) a difference of $9,000. So in essence taking out the $5,000 cost you $4,000 in additional growth.

If you have a substantial RRSP or equity in your property to use as collateral, it makes much more sense to borrow from the bank, even if the interest rate is higher than what you're making on your RRSP.

But that's only Reason 1 plundering your RRSP is a bad idea.

TAX IMPLICATIONS

If you ask to withdraw from your RRSP early, your financial institution will withhold part of your withdrawal. The withholding amount is set by the government so it is not negotiable. If you want to withdraw $5,000 early from your RRSP, you will receive a payment of $4,500. The more you withdraw, the higher the percentage withheld.

But in many cases, the withholding amount is not enough to cover your tax liability and you will end up owing at tax time. For example, if you earned less than $43,953, you are taxed federally at 15 per cent. If your withdrawal from your RRSP bumps your income over that number, the income over $43,953 is taxed at 22 per cent. So your short term gain to pay bills may result in another bill in April.

LOSS OF CONTRIBUTION ROOM

Unlike a Tax Free Savings Account (TFSA), once you withdraw money from your RRSP, the contribution room is lost. You never get it back. And though it may not seem like a big loss if your income is small, it is the longer term effects.

Your contribution limit is calculated based on earned income from the previous year. You may not be earning much in your first job but the unused RRSP contribution room is carried forward every year. The thinking is that as you earn more income, you can use the unused contribution room to bolster your RRSP savings. If you basically eliminated the unused room with an early withdrawal, you reduce the amount you can save for your retirement.

DON'T DO IT

Clearly, raiding your RRSP for a quick infusion of cash is a long-term loss. If you've got enough money stashed away in an RRSP that it's worth plundering, it's probably sufficient collateral to finance a personal loan for your emergency. Don't risk the tax implications.

It may seem like a short-term loan will cost you more money, but the magic of compound interest -- along with the lack of a tax hit -- will more than make up for your loan interest. Robbing your RRSP to pay another bill really should be your last option.

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