Canadian Investing - RRSP Early Withdrawals Penalty

[MichaelJohnson]

Hello all,
First official post... but long time reader!
Just a heads up... long post ahead... I've been mauling this over for some time.

Background:
If you hadn't guessed by the subject of the post, I'm a Canadian investor trying to board the Mustachian train.
I've read "Mr. Frugal Toque: Part 1" and am having a hard time figuring out the information in the article, versus what the CRA website is telling me.

I definitely understand the benefits of an RRSP account, but I'm finding a very specific discrepancy between the two when it comes to early withdrawal penalties!
According to the article, Canada is very good when it comes to early withdrawals on RRSP... as apparently there are no penalties, compared to South of the border.

What I found on the CRA website though... claims there are indeed "early withdrawal" fees:

When you withdraw funds from an RRSP, your financial institution withholds the tax. The rates depend on your residency and the amount you withdraw. For residents of Canada, the rates are:

10% (5% in Quebec) on amounts up to $5,000;
20% (10% in Quebec) on amounts over $5,000 up to including $15,000; and
30% (15% in Quebec) on amounts over $15,000.

So now my Scenario:
Let's say I decide to retire on an annual income of $15,000 a year at the ripe old age of 45. If I follow the 7% growth (spend 4% rule)... this would mean I need $375,000 to retire! (25 x 15,000 = 375,000)

Currently how I've read things is that I will be taxed in the following areas:
1) When taking the money out (which is at the 20% bracket above)
2) As an income of $15,000 for the year (the lowest tax bracket, but still tax)
3) Possibly on capital gains/dividends when I cash this money out? (I thought this was the point of keeping it in an RRSP though, to avoid this tax?)

My main concern is that extra 20% tax that wasn't mentioned in Mr. Frugal Toques article.
If we do some quick math only including the "early withdrawal" tax:
Year 46 of my life:
Withdraw 15,000 from my RSP (currently growing at 7% per year).
Withdrawal taxed at 20% = $3,000
$15,000 - $3,000 = $12,000

As you can see, I'm now $3,000 short in my annual living income, before I've had the income tax reduced!
By this logic, I would actually need to take out more than $15,000 a year to meet my annual spending needs. This would then bump me into the 30% tax bracket and also means I need to save much more than $375,000!

Okay Canadian Tax Experts and fellow Mustachians:
Tell me where I went wrong and what I'm misunderstanding!

The CRA mentions "Tax rates on withdrawals" as stated above:

• Are these the taxes that always apply when withdrawing from an RRSP? (Even after 65?)
• Is converting everything to a RRIF the key in saving me here?

Thanks for reading and any input!

References:
Mr. Frugal Toque: Part 1
http://www.mrmoneymustache.com/2013/09/21/canadian-investing-with-mr-frugal-toque-part-1/
CRA Withdrawals
http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/rrsp-reer/wthdrwls/menu-eng.html
The above link leads to "Tax Rates on Withdrawals"
http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/rrsp-reer/wthdrwls/rts-eng.html
RIFF Information
http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/rrif-ferr/menu-eng.html

[KMMK]

This is how I understand it:

The bank is forced to withhold a certain amount of "tax" but this number (20%) isn't necessarily the tax you will actually owe that year. The bank has no way of knowing what else you will be doing in any given year. You might owe more tax or less tax. So if are only earning/withdrawing $15,000 you will probably owe less than the $3000 that they withheld and you will get a tax refund. In the first year this will make your income less, but in the next years your tax refund will help make up the difference. So, say in April 2014 you receive a tax refund for the 2013 year of $2000, and you withdraw $15,000, but only get $12,000 because of the withheld amount. You have $14,000 to live on because your tax is only actually $1000.

When you are calculating your amount of expenses make sure to include the taxes. I'm not sure if your $15,000 included the taxes or not.

I'm not sure how close to are to actual retirement, but if you're like me it's 10 plus years away so this is all speculation. When I am closer to actual retirement I'll figure out how much I need to live on and work backwards to determine how much money to withdraw to get my expenses number after tax. Personally I set up a spreadsheet to plug in various numbers, but I'm sure there are various ways to do this.

Edited to add: I looked up the early withdrawal penalty for an IRA and it appears to be 10% on top of your normal taxes. In Canada you just pay your normal tax rate. But you are pre-paying this through your bank, the same way you pre-pay your tax through your employer on each paycheque during your employment. Your employer also just uses the formula supplied by the CRA, and you get things sorted out at tax season.

[MichaelJohnson]

Thanks for the reply Kestra.

I did some additional reading and it appears converting to a RIFF is the trick in Canada.
From what I've gathered (and for those who may not know), a RIFF is basically a reverse RRSP. Your entire RRSP account is converted to a RIFF and you begin making withdrawals.

Advantages:
- Your investments remain untouched, they continue to grow
- The only tax paid is income tax. The other 2 (withdrawal tax and capital gains) don't apply to a RRIF
- There are no maximums, you can take out as much as you want

Disadvantages:
- There is a minimum that must be withdrawn every year
- No more money can be added to the RRIF, so you rely primarily on growth at this point
- To my knowledge funds cant be moved around anymore

So to give my scenario again:
- $375,000 in my RRSP account, converted to a RRIF
- Theoretically I'm earning 7% ($26,250) a year and withdrawing 4% ($15,000)
- The RIFF will continue to grow faster than I'm taking out

You are definitely correct in pointing out including taxes in your calculatons. Even staying in the first tax bracket I will lose 20% to income tax.
This bumps my $15,000 a year to $12,000 as you've pointed out. ($15,000 x 20% = $3,000 in income tax)


One additional question I couldn't find an answer to though...
Is it possible to have both a RRIF and an RRSP account simultaneously?

Let's say I retire at 45, convert to a RRIF... but then earn some additional income on the side.
Would I be able to put this into a new RRSP? (Since my RRIF can't be modified)

[CanadianMustache]

Hmm... You've also given me some things to think about.

I've posted elsewhere but my husband is building up his business right now and we were thinking of using his rrsp money to pay off some debt while he's in a low bracket. I'll look into this RRIF thing as maybe that makes more sense. Pay off debt then continue to pull the minimum amount each year.

[RetiredAt63]

I'm mostly in the RRIF stage.

I also have a small RRSP.   So yes, you can have both.  But remember, once you have the RRIF you HAVE to take money out of it every year - over the year or one lump sum, the government doesn't care.  There are age-based minimums.  You do not have to wait until 71, if you do you suddenly have a big chunk coming out which may well affect your OAS that year and for years to come.

RRIF - when you set up your RRIF and arrange how much to withdraw, you can also determine how much income tax will be deducted at source, just as you do for work income.   You will get a T5 and use that when you calculate your income tax.

Withdrawing from an RRSP I am not as sure about - but I know people use that money for house down payments, now that there is no Home Owners Registered Savings Plan (that was how I saved my first house down payment, many many years ago).  The money that is withheld is income tax, since if you are pulling money out of an RRSP instead of a RRIF you are probably still working.  If I wanted to save for a house down payment or something similar, I would use a TFSA instead of a RRSP, the repayment rules are a lot gentler and you withdraw it tax free.  And remember, you can have just about anything (stocks, bonds, REITs, whatever) in a TFSA, just like in an RRSP.

[Gerard]

There seems to be some confusion here... or maybe all the confusion is in my mind. My understanding:

1. The money you pull out of an RRSP has tax withheld on it, but if your highest marginal rate is lower than the withheld tax, you get that money back. If you're planning full retirement, then, it's smart to pull out the maximum low-taxed amount every year until you have it all out (and roll the unspent amount into a TFSA, so its later earnings are all tax-free).

2. The downside of a RRIF not mentioned here: If you die with money still in it, the full amount is taxed (to your estate) as earnings in the year you die. So if there's a lot left in there, your beneficiaries will lose a whack o' cash.

3. The money you pull out of an RRSP to buy a house is tax-free. You only get taxed on it if you don't keep up with paying it back to your RRSP (1/15 of the withdrawn amount every year, or more if you like).

[sleepyguy]

I'm not too verse on the taxing withdrawal structure, but mind putting some details HOW you can live on $15k/yr in Canada?

[RealCanadianSavings]

I'm echoing what some of the other readers here have already said, but I thought I'd reply to try to make it more clear.

The withholding tax and the income tax are the same thing. The government just wants to ensure they get their cut before you have a chance to go spend it all! So, there is a blanket withholding amount taken off when you withdraw funds. Once you pay your income tax you'll get the difference back.

Also, if you withdraw $5,000 three times a year instead of $15,000 all at once then you'll only be charged 10% or $1,500 instead of $3000. This is because the withholding tax is based on the size of the withdrawal not on the amount withdrawn within the year.