RRSP withdrawal: When it makes sense to dip in

When you're a kid everyone tells you to keep out of the cookie jar. When you're an adult everyone tells you to keep out of your registered retirement savings plan.

Both can be tempting, and if you don't think it through, both can leave you with a pain in the gut.

Sure, it's your money and you can use it as you please, but the registered retirement savings plan was created in 1957 to encourage working Canadians to save for retirement, and the Federal government goes to great lengths to make sure it is used for that purpose.

There are, however, situations where there are few alternatives and in some cases withdrawing money from your RRSP makes sense.

As a last resort

For anyone with mounting debt or job loss an RRSP could be the only source of income. Any funds withdrawn are subject to a withholding tax. In most provinces, a withdrawal of up to $5,000 is taxed at a rate of 10 per cent, $5,000 to $15,000 is taxed at 20 per cent and over $15,000 is taxed at 30 per cent. Withholding taxes are slightly higher in Quebec.

When it comes time to file your taxes, the amount withdrawn is taxed at your regular rate depending on your income. If you're using it to pay debt and you are still working it is possible you will be forced to pay additional tax. Borrowers can apply to the Canada Revenue Agency for a reduction in withholding tax if you can prove the tax will cause undue hardship.

But if you lost your job and your income has been reduced or eliminated, you will likely get some or all of the withholding tax back in the form of a tax refund.

In addition to the withholding tax, funds withdrawn from an RRSP can not be re-contributed. That amount will be deducted from your maximum allowable contribution, which will limit the amount you can contribute in future years.

Home buyers

Under the Home Buyer's Plan (HBP) the Federal government allows first time home buyers, or home buyers who have not owned a house in the previous five years, to borrow a down payment from their own RRSPs. Plan holders are allowed to withdraw up to $25,000 without being slapped with a withholding tax.

Under the terms of the HBP, borrowers are given 15 years to return the money to their RRSPs. If withdrawing the maximum amount, the minimum you'll have to return is roughly $1,667 per year. If the money is not returned within 15 years, the RRSP holder will lose the contribution space forever.

Borrowing from an RRSP to buy a house allows homeowners to make a bigger down payment, and contribute more of their regular mortgage payments to owning the home instead of interest payments to the bank.

A bigger down payment can also allow homeowners to reduce or avoid mandatory mortgage insurance.

Back to school

The federal government will also cut RRSP holders some slack if they go back to school full time at a qualifying institution. The Lifelong Learning Plan (LLP) permits $10,000 to be withdrawn from the plan each year to a maximum of $20,000.

Under the LLP, repayments to the RRSP must begin no later than five years after the first withdrawal. After five years, plan holders have 10 years to return the full amount to their RRSPs. Like the Home Buyer's Plan, the contribution space for the amount not returned by the 10-year deadline will be lost forever.

The Lifelong Learning Plan is not as popular as the Home Buyer's Plan because many full-time students have little or no income anyway, and are in a low or zero tax bracket. From a tax perspective it may make more sense to simply withdraw the RRSP funds and sacrifice the contribution space.

On the downside, taking money out of your RRSP may be sweet at first but it means your savings don't grow within the plan. That's the way the cookie crumbles.