A Registered Retirement Savings Plan (RRSP) is one of the most useful tax planning tools under Canadian tax law. Your contribution to a RRSP provides an equivalent deduction from taxable income, and interest accumulating inside your RRSP is not subject to income tax. Since any withdrawal from a RRSP is subject to income tax, a RRSP mainly is accessed at retirement when tax rates are lower. Still, Canadians do have access to their RRSP funds at any time if they need them, but should be aware of the pitfalls of early withdrawal.
The main drawback of a RRSP withdrawal is that the withdrawal amount is subject to income tax in the year it is taken out. The effect of that tax is lessened in a year where the RRSP annuitant declares less taxable income, such as during retirement. If an annuitant makes an early withdrawal while still earning an income, that withdrawal will be taxed at a higher marginal tax rate.
For example, an annuitant living in Ontario and making $75,000 a year in salary and withdraws $25,000 from his RRSP will have that withdrawal taxed at the $100,000 level or a combined 37.16 percent (26 percent federal, 11.16 percent provincial, according to the Canada Revenue Agency 2009 Federal Schedule 1 and Ontario Tax Form 428), resulting in an income tax of $9,290 on that withdrawal. Conversely, if the withdrawal was made during retirement and the annuitant had no other sources of taxable income, that same $25,000 withdrawal would be taxed at a combined rate of 21.05 percent (15 percent federal, 6.05 percent provincial, according to the Canada Revenue Agency 2009 Federal Schedule 1 and Ontario tax form 428, resulting in a tax of $5,262.50; a tax savings of more $4,000.
Withdrawal May Have Surrender Charges
Some investments inside a RRSP have their own penalties for early termination, called back-end loads. A $25,000 early withdrawal with a 5 percent back-end load would cost the annuitant $1,250 in early surrender charges.
Lost Accumulated Savings
The early withdrawal also will have an effect on future retirement assets. That same $25,000 withdrawal, if taken out when the annuitant was age 35, will result in lost accumulation at age 65 of more than $143,000 if the RRSP was assumed to earn an average annual investment return of 6 percent.
Lost Potential Retirement Income
That loss of accumulated assets will also translate in a loss of potential retirement income. If an annuitant had $143,000 at age 65 and lived to be age 85, he could expect an annual income of $11,000 per year for 20 years assuming an investment return of 4.5 percent. That's $220,000 total income from age 65 to age 85. That single $25,000 early withdrawal at age 35 could end up costing the annuitant approximately $220,000 of income during his lifetime.