03/24/2014 05:26 EDT | Updated 05/24/2014 05:59 EDT

Cashing Out RRSPs Early Can Leave You With a Hefty Bill

Only first-time homebuyers or students can access RRSP funds without penalty

The deadline to contribute to your Registered Retirement Savings Plan (RRSP) has passed, ending a flurry of last-minute contributions for another year. RRSPs were designed to be long-term savings plans, but a recent study by Leger for H&R Block Canada showed 31 per cent of Canadians had withdrawn money from their RRSP or are considering it this year. If you find yourself cash-strapped now, it is certainly tempting to access that money, but there are some cautions to consider.

Your financial institution or fund company is required to withhold a certain percentage of the funds for tax purposes, and there are no exceptions. It does not matter if you will earn no other income during the year. These percentages are mandated by the federal government.

For amounts up to $5,000, you will have 10 per cent or $500 withheld, so you receive $4,500. For amounts between $5,000 and $15,000, 20 per cent will be withheld. For withdrawals greater than $15,000, 30 per cent is withheld.

This may seem a bit unfair, because it is your money. However, remember that you received a tax deduction when you made the deposit, and now that you have removed your money from the tax shelter of an RRSP, you have to pay tax on it. You will receive a T4RSP for your withdrawal and, although you can claim the withholding amount as a tax credit, the withdrawal amount is considered income and is reported on your tax return.

The withholding amount is meant to help with your tax liability but, in some cases, this amount will not be enough. Depending on your other taxable income and deductions, you may find yourself having to pay more.

There are only two ways to withdraw money from your RRSP without tax consequences, but both require the repayment of the money over a set period of time. The first is the Home Buyers Plan (HBP), which helps you buy your first home. The second is the Lifelong Learning Plan (LLP).

The HBP allows you to borrow up to $25,000 from your RRSP to buy or build your first home. You can also participate in the HBP if you are buying or building a principal residence for a disabled relative.

Only first-time homebuyers can use HBP. You need to complete Form T1036 -- Home Buyers' Plan Request to Withdraw Funds from RRSP to see if you meet the requirements. For example, if you owned a home, sold it and then didn't own another home for six years, you could be considered a first-time homebuyer again. As long as you meet the requirements, your financial institution will release the funds and you will not need to include it in income on your tax return. It will be reported on a T4RSP in Box 27 and you have to enter it on the Schedule 7.

You are required to start HBP repayments two years after you make the withdrawal. The annual amount of repayment will be indicated on your Notice of Assessment and is based on a 15-year pay-back period. If you do not make the annual payments, the amount will be reported as income, so ensure you have contributed enough to your RRSP during the year to cover the repayment.

The Lifelong Learning Plan (LLP) allows you to borrow up to $20,000 from your RRSP to return to school. Like the HBP, you have a specific timeframe to repay the money. Fail to make the repayments in time, and the money is reported as income.

In order to qualify for the LLP, you have to be enrolled on a full-time basis in a qualifying education program at a recognized post-secondary institution. As a general rule, the institution must qualify for the education amount to be eligible for the LLP. The program must last at least three consecutive months.

If you want to take advantage of the LLP, you need to complete Form RC96. You can withdraw up to $10,000 per calendar year and you are not required to use the money exclusively for education.

Repayment happens over a 10-year period, beginning no later than 60 days following the fifth year after you make the first withdrawal. Earlier repayment may be required if you do not attend school full-time for a minimum of three months in two consecutive years.

Until you retire, RRSPs are usually a one-way street: you put money in, and the funds stay there. But there may come a time when you need access to your funds sooner than you expect. Make sure you understand all the implications of the withdrawal before you make it. You may get the money to pay bills now, but it could lead to a tax bill when you file your return.


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