One of the major reasons why many people opt to invest in RRSPs is to take advantage of the tax breaks provided by the Canadian government. However, RRSPs are not tax-free. It simply allows you to pay taxes later and take advantage of tax breaks when you are in a lower tax bracket. In this article, we will talk about how to withdraw RRSP without paying tax.
Why is calculating RRSP tax so important?
RRSP is an abbreviation for Registered Retirement Savings Plan. It is a form of investment account registered with the Canadian government that allows Canadians to save for retirement while optimizing the amount of tax that must be paid in the current year.
Contributions to an RRSP are tax-deductible, which means that the amount contributed is deducted from the individual’s taxable income, lowering the amount of tax owed. RRSP savings grow tax-free until they are withdrawn.
Contributions and withdrawals from RRSPs are subject to numerous restrictions, and the government imposes annual contribution limits. Individuals can contribute up to 18% of their previous year’s income or a government-set maximum amount (the annual Max limit for 2022 is $29,210), whichever is lower.
You cannot always keep your money in an RRSP for as long as you want. After the age of 71, the RRSP must be changed into a Registered Retired Income Fund (RRIF).
You are not permitted to make further contributions to an RRIF after converting your RRSP to an RRIF. You must make minimum yearly withdrawals based on your age and the RRIF amount until you take all of the money from the RRIF.
Contributions to and withdrawals from RRSPs can have a considerable impact on your income tax.
Let’s assume that a person is a resident of Ontario and has no other deductions or credits. He earns 70,000 in 2022. Using the 2022 federal and Ontario tax rates, here’s how their taxes would be affected:
Without RRSP contribution:
- Income: $70,000
- Federal tax payable: $8,543
- Ontario tax payable: $4,303
- CPP/EI Premiums: $4,453
- Total tax payable: $17,299
With RRSP contribution:
- Income: $70,000 – $10,000 = $60,000
- Federal tax payable: $6,538
- Ontario tax payable: $ 3,388
- CPP/EI Premiums: $4,453
- Total tax payable: $ 14,334
By contributing $10,000 to their RRSP, this person’s taxable income is reduced to $60,000. This means they move down to a lower tax bracket, and their federal and provincial taxes are both reduced. In this example, they would save $2,965 in taxes for the year.
But, withdrawing RRSP might have a significant impact on your income tax.
Assume the above-mentioned person is still a resident of Ontario and has no additional deductions or credits. Using the 2022 federal and Ontario tax rates, here’s how their taxes would be affected:
Without RRSP withdrawal:
- Income: $70,000
- Federal tax payable: $8,543
- Ontario tax payable: $4,303
- CPP/EI Premiums: $4,453
- Total tax payable: $17,299
With RRSP withdrawal:
- Income: $70,000 + $10,000 = $80,000
- Federal tax payable: $ 10,593
- Ontario tax payable: $ 5,368
- CPP/EI Premiums: $4,453
- Total tax payable: $ 20,414
By withdrawing $10,000 from their RRSP, this person’s taxable income is increased to $80,000. This means they move up to a higher tax bracket, and their federal and provincial taxes are both increased. In this example, they would owe an additional $3,115 in taxes for the year.
To sum up, if you withdraw from an RRSP while you are in a higher tax bracket, you pay more tax than you profit from. That is why calculating RRSP tax is important.
How to withdraw RRSP without paying tax?
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Use the Home Buyers’ Plan
The Home Buyers’ Plan (HBP) is a program in Canada that allows first-time homebuyers to withdraw up to $35,000 (the amount is $70,000 for a couple) from their Registered Retirement Savings Plan (RRSP) to put toward the purchase or construction of a qualifying home.
The first-time home buyer restriction is quite liberal. A first-time house buyer in Canada is commonly described as someone who has never owned a primary property anywhere in the world, as well as someone who has not had a primary residence for at least 4 years prior to purchasing a home in Canada.
This type of RRSP withdrawal is considered a tax-free loan, meaning that as long as the funds are repaid within 15 years, they will not be subject to income tax.
Suppose you have an RRSP with a balance of $40,000 and you’re planning to buy your first home. You can withdraw up to $35,000 from your RRSP under the HBP without having to pay any tax on that amount.
To withdraw from your RRSP via the HBP, you must fill out and return Form T1036 to the Canada Revenue Agency (CRA). You must refund the amount withdrawn within 15 years (If you use $35,000 from your RRSP, you will pay $2,333.33 every year.), beginning in the second year after the money was withdrawn.
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Use the Lifelong Learning Plan
The Lifelong Learning Plan (LLP) is another government program that allows you to withdraw from your RRSP tax-free. The LLP allows you to withdraw up to $20,000 over 5 years to finance your or your spouse’s or common-law partner’s education or training.
Individuals can withdraw up to $10,000 per year from their RRSP under the LLP, for a total of $20,000 over a four-year period, to support their education or training. The withdrawn amount is not taxable as long as it is repaid to the RRSP within 10 years.
To be eligible, you must be a Canadian resident and enrolled in a recognized educational program at a designated educational institution to be eligible for the LLP. You must also be the owner of the RRSP or the owner’s spouse or common-law partner.
To withdraw from your RRSP via the LLP, you must fill out and return Form RC96 to the CRA. You must reimburse the amount withdrawn within 10 years, beginning five years after the money was withdrawn.
Even though the LLP offers many advantages, there are certain restrictions on which schools are eligible for funding. The program is intended to assist with education and training programs that lead to a recognized educational certification, such as a diploma, degree, or certificate. This implies that the institution you attend must be recognized as a competent educational institution by the government.
In general, eligible institutions include:
- Government-designated Canadian universities, colleges, and trade institutions for the purposes of the Canada Student Loans Program.
- Educational institutions outside of Canada that fulfill specific criteria, such as being recognized by the country’s educational authority and offering courses comparable to those given by Canadian educational institutions.
- Colleges that provide professional certification courses in areas such as languages, computer programming, or accounting.
It is important to keep in mind that not all educational programs or courses will be eligible for LLP financing. It’s always a good idea to check with the school you want to attend to see whether you’re eligible and to understand the potential tax consequences of using the LLP to finance your education or training.
You can combine the Home Buyers’ Plan with the Lifelong Learning Plan to get a total tax-free RRSP withdrawal of up to $55,000 per person. If you have a partner, you can take up to $110,000 from your RRSP tax-free.
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Withdraw from Your RRSP When You’re in a Lower Tax Bracket
When you withdraw money from your RRSP, the amount is added to your taxable income for the year. This implies that if you make a significant withdrawal, you may find yourself in a higher tax bracket and have to pay more taxes. However, if you are at a lower tax rate, you can withdraw from your RRSP without having to pay as much tax.
For example, if you retire and your income drops dramatically, you can withdraw from your RRSP without paying as much tax. Alternatively, if you take a year off from work to travel or take a sabbatical, you may be in a lower tax bracket and so able to withdraw from your RRSP without paying as much tax.
Here’s an example to illustrate this point:
Let’s say you live in Ontario, and you made a $10,000 RRSP contribution when you were in a high tax bracket with a marginal tax rate of 37.91%. This means that you received a tax refund of $3,791 (37.91% of $10,000) when you made the contribution.
If you didn’t work much this year and your income has dropped dramatically to $20,000, putting you in a lower tax bracket with a 20% marginal tax rate. Now, you will pay $2,000 in taxes if you withdraw $10,000 from your RRSP. Even after deducting taxes, you’re still $1,791 ahead. ($3,791 return – $2,000 taxes).
In this case, withdrawing from an RRSP in a lower tax bracket saves you money since you could contribute to the RRSP while your tax rate was higher and withdraw when your tax rate was lower, resulting in net tax savings.
Furthermore, if your income is less than the basic personal amount, you may be entitled for a refund of any taxes deducted from your income and therefore receive a greater tax benefit.
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Consider a Spousal RRSP
If you are in a higher tax bracket than your spouse or have much more income than your spouse, you can lower your taxes by contributing to a spousal RRSP. You can contribute to your spouse’s RRSP using a spousal RRSP, and the amount will be deducted from your income for tax reasons as well.
Let’s take an example to illustrate how contributing to a spousal RRSP can lower your taxes:
Suppose that John and Jane are a married couple:
- John earns $120,000 per year, and Jane earns $30,000 per year.
- John’s marginal tax rate is 43.41%, while Jane’s marginal tax rate is 20.05%.
- Suppose John contributes $10,000 to a spousal RRSP in Jane’s name. This will reduce John’s taxable income to $110,000, which would have reduced his tax bill by $4,341 (43.41%, of $10,000).
- Jane’s marginal tax rate is 20%, thus if she withdraws $10,000 from her RRSP that John contributed to in a year, she will only pay $2,000 in taxes (20% of $10,000).
- As a result, the family saved $2, 341 in taxes.
Having said that, when your spouse withdraws money from the spousal RRSP, the amount is added to his or her taxable income. If your spouse has a lower tax bracket than you, they will pay less tax on the withdrawal. This method allows you to save tax on your RRSP withdrawal.
Do I have to pay taxes on RRSP withdrawals when I retire?
Yes, you will have to pay taxes on RRSP withdrawals when you retire. When you withdraw money from your RRSP, the amount is deemed taxable income for the year and is taxed at your marginal tax rate in the year of withdrawal.
As a result, do not take the whole amount of your RRSP in one lump payment; otherwise, you will face a significant tax bill. Because the whole amount of the withdrawal will be added to your taxable income for the year, putting you in a higher tax bracket.
For example, if you retired with $250,000 in your RRSP and wanted to withdraw it all at once, your tax burden would be tremendous. Assuming you had no additional income in the year of withdrawal and lived in Ontario, the combined federal and provincial tax rates for the 2022 tax year would result in a marginal tax rate of about 53.53% on the $250,000 withdrawal. More than half the amount.
Hence, if you have a large amount of money in your RRSP, you should never withdraw it all at once.
Conclusion
To summarize, withdrawing from your RRSP before the age of retirement can be a significant financial choice. But there are tax-free, or tax reduction strategies to withdraw from your RRSP, such as the Home Buyers’ Plan and the Lifelong Learning Plan. There are also ways to reduce your tax liability, such as withdrawing when you’re at a lower tax rate or considering a spousal RRSP. Before making any withdrawals from your RRSP, you must carefully research your options and understand the tax implications.
