Is taking money out of your RRSP to pay off debt ever a good idea?

Four things happen when you withdraw money from your RRSP to pay off debt.

First, you get money to pay off your expensive debt and probably feel a lot of relief.

Second, you’ll pay taxes (and possibly exit fees when the investments are sold).

Third, you won’t get this associated RRSP room back once you’re on your feet and ready to contribute again.

Fourth, you could jeopardize your retirement preparedness.

My advice to anyone feeling like RRSP withdrawal is their best option (probably their only option): go easy on yourself. An exceptional circumstance, like crushing levels of debt, might be a good reason to do so. But make a plan to ensure this situation doesn’t happen again. That’s because the financial consequences of early RRSP withdrawal are steep.

Seek advice

Especially if you’re experiencing anxiety and/or depression as a result of your debt, a clear, fact-based evaluation of your options is critical. I recommend meeting with a financial adviser immediately to assess the debt situation. 

Alternatives they might suggest could include meeting with a licensed insolvency trustee to explore a consumer proposal (this tool protects your RRSPs); a debt consolidation (pulling all the balances together under one new loan at a lower rate and total lower payment); or the snowball debt-reduction strategy for a few months first, to see if you can make progress.

Dig into the numbers

A good adviser will also walk you through the specific financial implications of withdrawing RRSP funds for your unique financial picture. They will calculate:

• The RRSP withholding tax: That’s right, immediately you will lose money to taxes and will want to take that into account as you’re trying to tidy up your debt. The tax is determined by how much you take out and where you live. For most of Canada, the withholding tax rate starts at 10 per cent and grows substantially to up to 30 per cent the more money you take out.

• Whether your income taxes might go up: RRSP withdrawals are reported on your tax return as income, and you will pay taxes on that income. This might also move you into a higher tax bracket altogether. There may be a very specific situation where your income has gone down — a long-term period of unemployment or illness — and taking out the RRSP money in a year when you’re earning much less won’t actually skyrocket your taxes.

• Your RRSP contribution limits: You don’t regain the room back in your RRSP, so your adviser will help you understand the room you still have (if any), and what you can expect to accumulate in terms of RRSP room every year going forward.

• The implications to your long-term financial plan for retirement if you withdraw this money today. 

• The clear benefits of debt freedom such as precisely how much your cash flow will improve when you’re clear of debt, the impact to your net worth, what should happen to your credit score, the savings on the interest you’re paying, and your ability to save money and avoid debt altogether in the future.

Some advisers and money coaches will also directly support you in building a new budget and a new financial plan to help you get back on track after you’ve cleared the debt. This is essential for your financial well-being moving forward. You’ll probably hear their advice around your income, saving and spending habits, too — soak it up.

With this concrete advice, you’ll know exactly how an RRSP withdrawal can help or hinder your financial situation, and you can make an informed decision. Who knows? You may end up empowered with a completely different strategy; perhaps to use your RRSP to invest in your education and hopefully get a better income (RRSP Lifelong Learning Plan) or to eventually buy a home (RRSP Home Buyers’ Plan). Or, maybe an RRSP withdrawal is the right thing for you to deal with your debt, and you can embrace this strategy knowing better financial days are ahead.

This article was originally published in The Star. Lesley-Anne Scorgie is a Toronto-based personal finance columnist and a freelance contributing columnist for the Star.