You’re trying to improve your financial health but all the messages are getting confusing. First there are the warnings that Canadians need to pay off their high levels of debt. But now it is RRSP season, and you are wondering about your retirement savings. You’ve managed to salt away a small amount of money for an RRSP contribution and are asking yourself some debt versus RRSP questions:
- Should you be putting the money towards your debt?
- Should you instead put the money into an RRSP? or
- Should you even consider withdrawing some of your current RRSP savings to pay off debt.
Which choice is better? The answer lies in the details of your personal situation.
The average Canadian owes 163% of their take home pay in debt. We all agree that number is too high. On the flip side, Statistics Canada recently reported that just less than 1 in 4 Canadians made a contribution to their RRSP in 2011 and that the median contribution was $2,830. Is that enough to ensure that you have a reasonable retirement lifestyle?
When deciding whether or not you should pay down your debts, make a contribution to your RRSP or withdraw your current RRSP or other savings to apply towards debt reduction, there are a few things you should consider.
What type of debt do you have?
If you are carrying high interest credit card debt it is highly unlikely that you will be earning enough in your RRSP to offset the cost of paying 18% or more on your credit card debt. On the other hand, if your debt is primarily your low interest mortgage, then repaying your mortgage debt sooner at the expense of your retirement savings may not be as financially rewarding. Use this pay down debt or invest calculator to help you decide if your cost of debt outweighs the income generated from your RRSP.
What are the tax costs of withdrawing your RRSP?
Withdrawing your RRSP savings to pay down your debt can have unexpected tax consequences. Your bank or financial institution will be required to withhold a portion of the amount you withdraw, reducing the amount you can apply towards debt reduction. The RRSP withholding taxes range from 10% to 30%, depending on how much you withdraw. The more you withdraw, the higher the withholding tax. But don’t think you should withdraw multiple small amounts to avoid a larger withholding tax. You will more than likely just end up with a large tax debt at the end of the year, putting you in more financial trouble.
If you are wondering about making an additional contribution this year, the question becomes what is your tax bracket now compared to when you expect to retire and what are your current debt payments like. Are you already having difficulty making your monthly debt payments? How much do you need to reduce your debt by now to make those monthly payments affordable?
A higher tax bracket today will result in a higher tax refund. Ask your financial institution to help you with the calculations to see how much your refund will be before you make a new contribution. Will that tax refund, once applied towards your debt, reduce your monthly debt payments to a level you can afford to pay? If not, then you may want to consider applying the full amount of your small surplus directly to debt reduction.
How close are you to retirement?
This is a hard one. The closer you are to retirement the more you will need to have in your RRSP to support a comfortable lifestyle once you do retire. But carrying debt into retirement is also a bad idea. The higher your debt going into retirement the more income you will need to pay your monthly living expenses, including interest on your debt. It’s a vicious circle that is hard to navigate. Generally, financial experts agree that you should enter retirement debt free. In that case, you may want to apply this year’s contribution money towards reducing your debt but leave your current RRSP and other savings as is.
Will your employer match your contribution?
If you employer has a program that matches, or partially matches, your personal RRSP contributions each year you will again want to look at the math. If you pay down debt, how much interest will you save compared to how much of an additional contribution your employer will make towards your RRSP savings.
Alternatives to Withdrawing Your RRSP to Pay Down Debt
If, after looking at the above questions, you are still wondering whether or not you should withdraw your current RRSP to reduce your debt, the final factor to look at is what other debt repayment options do you have?
If most of your debts are high interest credit card debt, and you still have good credit, you may want to consider applying for a debt consolidation loan to repay those debts rather than withdrawing from your current RRSP. This will combine your payments into one monthly payment and lower your interest costs.
RRSP’s, RRIF’s and Pensions Are Now Protected From Creditors
If your debts are overwhelming, you may be considering filing for bankruptcy. It is important to know that if you go bankrupt, you now keep your RRSP in a bankruptcy except for contributions made in the last 12 months.
Make a consumer proposal to your creditors.
If you do not qualify for a consolidation loan, and are having trouble meeting your monthly payments without withdrawing significant funds from your RRSP, you may want to consider talking to a Trustee in Bankruptcy about a Consumer Proposal. A proposal can help you reduce your debt without declaring bankruptcy and without jeopardizing your retirement.
The ultimate choice to pay down debt or invest in an RRSP is a matter of balance. If you can afford your monthly payments and are on track to pay off your debt in a reasonably short time period, then it may make sense to add to your retirement savings. If on the other hand your debts are not manageable, paying down those debts should be your number one priority – but don’t forget to consider all your options.