This is our first Technical Tidbits edition of Debt Free in 30, a shorter version of our podcast where we answer just one listener question.
Today’s question is:
Should I use money in my RRSP to pay off debt?
The answer depends on:
- How much debt you have; and
- What type of debt you have.
Liquidating assets to pay down debt
On the surface this appears to be a relatively simple question to answer. If you owe money, and you own something of value, it makes sense to turn your asset into money you can use to pay off your debt.
If you own an older car that you no longer need, it makes sense to sell it and use the cash to pay off your credit card. It’s a no brainer.
But RRSPs are different, and they are different because of one little three letter word:
If you bought your car for $5,000 four years ago and you sell it today for $3,000, you don’t have to pay any income tax on the sale, because you didn’t earn any income. In fact, in this example, you technically lost money, so you end up getting to keep the entire $3,000 and you don’t have to worry about paying any income tax.
Tax costs of RRSP withdrawal
It’s totally different with an RRSP.
If you take $3,000 out of your RRSP, you must include the $3,000 in your income, and you pay tax on that $3,000 at whatever your marginal tax rate is.
That’s because an RRSP is not a way to save tax; it’s a way to defer tax. You get a tax break when you contribute to your RRSP, but you pay tax when you take it out.
The theory is that you contribute to your RRSP when you are working and in your high tax earning years, and you take the money out when you are retired and in a lower tax bracket. Makes sense.
But if you are still working and take money out of your RRSP, you may still be in a high tax bracket, so you pay a lot of tax on the withdrawal.
What’s worse, you may not even know how much tax you will have to pay.
If you withdraw under $5,000 from your RRSP, the bank, in Ontario, will withhold 10% for tax. But at the end of the year, if you happen to be in the 40% tax bracket, you have to pay 40% in tax. You only paid 10% up front, so surprise, you end up owing another 30%, or $1,500 in this example. That’s a big bite.
So, back to our question: should you take money out of your RRSP to pay off your debt?
You must calculate how much you will end up paying in tax when you do. If you are in the 40% tax bracket and you take out $10,000, you really only get to keep $6,000 once your taxes are filed and paid.
Is it worth it to lose $10,000 from your RRSP to get $6,000 to pay off debt?
Maybe, maybe not.
Part of the decision depends on how much you are paying in interest on your debt. If you have $6,000 in payday loans at a huge interest rate, and if you are only earning 1% in your RRSP, it’s probably an easy decision to use the money to pay off your debt.
If you have a mortgage at 3% interest, cashing in your RRSP and taking a big tax hit probably isn’t worth it, unless you really want to be debt free.
But what if you have a lot debt, say $50,000, $60,000 or even more owing on credit cards, bank loans, income taxes, and other unsecured debts?
When not to use your RRSP to pay off debt
If you don’t have enough in your RRSP to cash it in, pay the tax, and pay off your debts in full, there is another option.
If you have more debt than you can handle, and if you are behind on your bill payments and collection agents are calling, it may be time to consider a consumer proposal or personal bankruptcy.
Here’s the key point:
It is possible to go bankrupt and not lose your RRSP.
The Bankruptcy & Insolvency Act, which is federal legislation, says so.
Section 67 of the Bankruptcy & Insolvency Act says that, if you go bankrupt, your trustee is NOT allowed to take your RRSP, except for your contributions in the last 12 months.
So, if you have an RRSP that you haven’t contributed to in the last year, and you go bankrupt, the trustee can’t take your RRSP.
If you have an RRSP through work that you contribute $100 per month to, and you’ve been contributing for 10 years, all you lose is the $1,200 you’ve contributed in the last 12 months.
So if you have $50,000 in debts that are more than you can ever hope to repay, and an RRSP with savings accumulated from before the past year, a consumer proposal or bankruptcy may be a good option. You can clear up your debts, and not lose your RRSP.
I’ve met with many people over the years who have tried to keep up by draining their RRSP for the last year or two, and now that it is completely drained they come in to see me because they can’t keep up, and now they need to go bankrupt. I say, “it’s too bad you didn’t come to see me two years ago, because we could have done the bankruptcy or a consumer proposal two years ago and you could have kept your RRSP. Now that you have already cashed it in, it’s gone”.
So here’s my advice:
If your debts are small, and you aren’t earning much in your RRSP anyway, and you can afford to pay the tax, fine, go ahead and cash in your RRSP to pay off your debts.
However, if your debts are large, and if even cashing in your RRSP won’t solve your problem, you need to consult with a licensed insolvency trustee. We can crunch the numbers and help you decide if you should cash in your RRSP to pay your debts, or if you should consider other options.