Taking RRSP Money Out Early to Invest
Taking RRSP money out early to invest is not a strategy that the Canadian government wants you to deploy. The main reason why it is tax deferred is to keep people from withdrawing funds out early and spending it on fur coats and vacations. Unfortunately, what works for most does not suit everyone. Policies are in place to cater to the lowest common denominator. RRSPs do make great financial investment vehicles and offer people, myself included, a great way to grow wealth tax-free.
The downlow on RRSPs
The Canadian government has extended its rules around early withdrawals for particular items they see as a life-long investment. These include helping people buy their first home with the Home Buyers Plan and the Life-Long Learning plan to fund full-time tuition. The amounts withdrawn will have to be paid back eventually, but it serves as a better option that taking out a line of credit where you would have to pay interest on that money.
The penalties in place to withdraw early are in effect to deter people from doing just that. Penalties include an early withdrawal tax up to 30%. The full amounts can be seen on the Canadian government website here:
On top of that, when you do your taxes, you may have to pay extra if you are normally taxed at the 30% tax bracket. Additionally, when you make an early withdrawal from your RRSP money, you lose the contribution room of those funds permanently. If you took out $10,000 early, you’ll never be allowed to re-contribute it, which reduces the potential value of your total RRSP money at retirement.
So why am I trying to break tradition and get you to think about early withdrawals? Because sometimes the math simply makes sense. It is not based on what you feel is right, it is all based on how the numbers fit into your personal mission.
When does it make sense?
So who would benefit from early withdrawals? Well, for someone who plans on making more into retirement than they currently do. This is a small population, no doubt, but one worth the pursuit. It may also be for someone who plans to create the same amount of income, or close to their current level into retirement which is completely possible given the right investing decisions.
But let’s look into an everyday persons’ RRSP withdrawals in retirement. If, in retirement, the person is making $50,000 a year, in Alberta they would be paying a 30.5% tax on that money. Remember, it is tax DEFERRED, not tax EXEMPT! If they currently make $90,000 in income they are still paying 30.5% tax whether they pay now or later. In this case, money in your pocket now is better than money in your pocket later because you know you can actually benefit from it.
ALBERTA TAX CHART
You need to analyze the time value of your money if you choose to use it for investment. If you plan on taking out $75,000 of RRSP money to purchase an investment property, you will need to take out $108,000 to get the $75,000 you need after the 30.5% tax is applied. Next, compare the time value of that same money with projected ROI.
The investor is debating taking out $108,000 for rental property ($75,000 after tax) with a projected 22% ROI over 10 years. The profit will be variable, but using conservative estimates of 2% appreciation/yr and 8% vacancy rate on a $350,000 property, profits would be around $165,500. $165,500/ $75,000=2.20 divided by 10 years = annual ROI of 22%.
See the realistic financials here:
Next, calculate how much your RRSP of $108,000 will grow to at your current rate of return. Using an average number of 7%, your money will see a $109,000 profit in those same 10 years. In fact, the RRSP money has an advantage in that it gets compounded yearly and it still comes $56,500 short!
Don’t only take my word for it. After all, I am no accountant. There is a great blog post from a real estate accountant who makes the case that it may be worth while to make early withdrawals from your RRSP money, which may give you more confidence.
Some points you need to consider are if you are paying any hidden MER fees. Recently, I showed a friend that she was paying 2.15% in fees (avg is 2.35%). Given the same parameters, a 7% ROI would actually be 4.65%. Over that same 10 year horizon, she would only have $62,000 in profits instead of $109,000. Small leaks sink BIG ships!
Another consideration is being confident you can keep a 7% ROI. Before choosing your investment approach, or any specific investment, consider the risk involved, your risk tolerance and your time horizon. I have my own interesting take on the risk you can read HERE. Investing does not have to be complicated, but your future self will thank you for making smart, upfront research decisions before you throw your money at a well-diversified portfolio for someone else to manage. Feel free to CONTACT ME for any guidance.