ONE OF THE HARDEST FINANCIAL DECISIONS OF YOUR LIFE MIGHT BE WORTH IT
A reader question about whether it was savvy to cash in an RRSP to pay off Debt was submitted to Mr.CBB. He forwarded it to me to share my opinion on this topic with all of you.
My short answer is that it depends.
Cashing your RRSP’s
There are several factors to consider if you are thinking about cashing your RRSP’s.
- The age of the person
- The withholding tax on the funds withdrawn on the RRSP
- The amount of debt and its’ interest rate
- The type of investment held in the RRSP
- The opportunity cost of the withdrawal
To keep things simple let me say if you are doing this and are under 30 then it might not be a bad thing. At older ages you have a shorter accumulation period and time and the magic of compound interest work against you.
I have always maintained that paying off debt is one of the best investments someone can make.
Let’s say you’re carrying a credit-card balance of $1,000 with 18 percent simple annual interest. That’s $180 a year in charges. Pay off that debt and you’ve saved $180. That’s the same as investing $1,000 in something that earns an 18 percent return after tax.
Tax withholding rates
When you withdraw funds from an RRSP there is a tax withholding. This is a credit due for taxes payable on 100% of the withdrawal and is to be paid by April 30th in the year following the withdrawal. You may indeed owe more than the rate withheld if you have a high income.
|Withdrawal Amount||Tax Withholding|
|From $0 to $5,000||10%|
|From $5,001 to $15,000||20%|
|Greater than $15,000||30%|
So let’s assume you have $10,000 in debt. You are paying the minimum of 3% per month to carry the debt or $300 per month. The debt carries an interest rate of 18%.
Approximately $14,300 needs to be withdrawn to net the $10,000 to pay off the debt. Your savings, the cash flow of $300 per month after the debt is eliminated.
However the real cost may be much greater.
What would the $14,300 be worth at age 65 at 6% yield if it had never been withdrawn?
If you were 35 when you did this, the monies would be worth at 65, $83,281 so you are giving up potential growth on this money in addition to the withholding tax.
Ok, I hear the question already: What if we withdraw, pay off the debt, and invest the $300 a month every month to age 65?
If you indeed did do this, your deposits would be worth $294,354. In this example provided you have the discipline to save the $300/mo. it indeed might work out to eliminate the debt first.
What if our client was able to find savings through budgeting etc. and find an additional $300 per month?
In 19 months he/she would be debt free, their RRSP would be intact, and now they can save even more toward their future.
Under step 2, choose minimum payments. This shows the real cost of paying credit cards on a minimum payment basis. On page 2, change the monthly payment to $600. See the result? You may want to bookmark this calculator.
Ideally this would be the preferred course of action.
If your RRSP’s are earning low rates of return, such as 2% or 3% it makes it easier to withdraw monies and eliminate the debt. Your opportunity cost (Put another way, the benefits you could have received by taking an alternative action.) is not very great because of the low yield on the investment.
So there you have my analysis on whether you should cash in your RRSP’s to Pay Off Debt!
Would you pay off the debt first?
Look for the savings through budgeting and keep the RRSP intact?
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