There is no shortage of creative ideas about how to use a registered retirement savings plan. I've seen people use them as a vehicle to save for a home through the Home Buyers' Plan (HBP), or for education through the Lifelong Learning Plan (LLP), and as a short-term savings account -- much like a bank account.
While I'm not keen on the HBP or LLP, the idea of using an RRSP as a short-term savings account, where withdrawals are made from the RRSP shortly after contributions are made, really makes me cringe. RRSPs are not well suited for the short-term saver.
In fact, there are seven potential problems in using your RRSP as a short-term savings account:
Problem 1: You slow the growth inside the plan.
The biggest drawback to using an RRSP as a savings account is that the premature withdrawals will slow the growth inside your plan.
Is this really a big deal? It can be. Suppose that you're 40 today, plan to retire at 65 and withdraw $10,000 from your RRSP this year. If we assume a 10-per-cent annual rate of return inside the plan, that withdrawal will result in having $108,347 less in your RRSP at age 65.
Problem 2: You throw away contribution room.
A more subtle problem is that making premature withdrawals will result in lost contribution room. If you put $10,000 into your RRSP on or before March 1 of this year, you'll use up $10,000 of contribution room in the process. If you then withdraw $10,000 from the RRSP shortly thereafter, the tax man is not generous enough to give back that contribution room.
Problem 3: You may fail to match investments with objectives.
If you're like most Canadians, you may have had good intentions when you put money into your RRSP. You probably contributed money to the plan and put it into the kind of investments most people hold in their RRSPs, particularly equity mutual funds or stocks. But if you later decide to use the RRSP as a source for short-term cash needs, you'll likely have to liquidate some of those investments.
The problem? You may be selling at a time when your investments have dropped in value. This can easily happen with equities over the short term. Money that's going to be needed in the short term is best left in money-market securities or similar investments.
Problem 4: Withholding taxes generally apply.
If you've ever made a withdrawal from your RRSP, you'll no doubt understand the concept of withholding taxes. When you make a withdrawal from your plan, the financial institution is required, in most cases, to withhold a certain amount of it and remit the withholdings to the tax man as an instalment on your taxes owing on that withdrawal.
The withholding rates federally are 10 per cent on withdrawals up to $5,000, 20 per cent on withdrawals from $5,001 to $15,000, and 30 per cent on withdrawals over $15,000. Quebec's revenue agency levies withholding taxes of 25, 33 and 38 per cent respectively on the same amounts. These withholding taxes could leave you with a bit less to spend.
Problem 5: Spousal plans can result in attribution.
If the plan that is being raided is a spousal RRSP, the withdrawals could be taxed in the hands of the contributing spouse and not in the hands of the annuitant spouse (the one making the withdrawals).
This could result in more tax than you thought. Specifically, the withdrawal will be taxed in the contributor's hands to the extent that there were contributions to any spousal RRSP in the year of the withdrawal or in the two previous calendar years.
Problem 6: You may incur fees.
If you've invested in mutual funds inside your RRSP and you've purchased them on a deferred-sales-charge basis, there will likely be a charge if you liquidate those funds in the short term as you make withdrawals from the plan.
The sales charge typically starts out at about 7 per cent and usually falls over the course of several years. In addition to a deferred sales charge, using the RRSP as a short-term savings account can result in short-term trading fees. Some investment dealerships may levy this type of fee if trading takes place within 90 days after purchasing an investment.
Problem 7: Trustee fees may hurt you.
Finally, if your RRSP happens to be a self-directed plan, there's a good chance you're paying a trustee fee each year of about $100. While it may not seem all that significant, treating your RRSP as a short-term savings account will mean that this fee may be a higher percentage of your investments than it should be.
For example, if you have $20,000 in your RRSP and you pay $100 annually, the fee represents just a half per cent of your total assets. If, however, you withdraw $10,000 from that RRSP, your trustee fee suddenly becomes 1 per cent of your total assets.
That'll eat into your investment returns. You want your RRSP assets to grow annually so that fees like this become negligible as a percentage of total assets.
There may be some cases where making premature withdrawals from an RRSP can make sense, such as when your retirement is being looked after in other ways.
The truth is, however, that the type of people most likely to use their RRSPs as a short-term savings account tend to be those who find cash flow tight on a regular basis. This can include lower-income Canadians or those who are living beyond their means.
If it's inevitable that you'll need to make withdrawals from your RRSP because of cash-flow shortfalls, you're probably better off not putting money into the plan initially. Investing in money-market securities outside your RRSP may be a better way to go.
Above all, don't forget about the importance of building retirement savings.
Speak to a trusted financial adviser about your specific circumstances if you're not sure about the right thing to do.
Tim Cestnick is managing director of Tax Smart Services at AIC Ltd.
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