Are you drawing on your RRSP or perhaps, you’re drawing on your RRIF and you have no idea how the withholding tax works?
The RRSP withholding tax to me is a very critical part that people just don’t understand.
Withdraw from RRSP
First, let’s start with your RRSP. You have been saving, contributing and getting the deduction against your income. Now, for whatever reason you need to withdraw it. You decide to draw on your RRSP.
How does it actually work?
Hopefully, you’ve looked at your cashflow situation and at optimizing your cash flow. Have you spoken to your advisor about whether or not this is actually the optimal move? Ideally, drawing on an RRSP is typically not something you want to be doing unless you absolutely need to for cashflow purposes.
If there are other sources of income and if there’s another way for you to figure out your cash situation, it’s something you should absolutely consider. However, let’s say you do need the income, you’re drawing on your RRSP for whatever reason.
First, if you’re drawing on your RRSP for a deposit on a first-time home that you’re buying, you should consider and look at the RRSP first time home buyers plan, because that allows you to take some money out of your RRSP and just pay it back over time.
Now, if you need the money for something else, regardless of what it is, the government has mandatory minimum withholding taxes that financial institutions must withhold from your withdrawal. The first $5,000 that you withdrawal, you’re going to be paying 10%, from $5,000 to $15,000 you’re going to be paying 20%. $15,000 plus you’re going to be paying 30%, and that is the minimum required withholding tax. Now, some institutions do it differently than others, but for most institutions it is a cumulative amount over the years.
If you take out $5,000 today, you’re going to pay 10%. And if you take out another $20,000, well the difference will be the cumulative tax rate. At the end of the day, if you end up taking 20K, 30K or 40K, all of that will be withheld at 30%.
Now the tax rate that is being withheld is an important factor. That is not your tax rate. The withholding tax is not your actual marginal or effective tax rate. I repeat, It’s not your tax rate. You will pay at the end of the year. When you file your taxes in April and you’re going to look at your entire income for the year, which would include any RRSPs withdrawn.
One of those slips will be a T4RSP, which will show all the money you took out from your RRSP. It will be added to your other income. Your tax credits, your charitable contributions and whatever else you got going on that year for your personal tax situation will be added to your income.
If you are in a top tax bracket, which is about 50% in most Canadian provinces and if you draw down on your RRSP, you are going to pay a 50% marginal tax on that RRSP withdrawal.
You may have already paid 10, 20, or 30% in withholding taxes on your RRSP withdrawal at the source, this amount will cover part of the taxes that you will owe for the year. The withholding tax is merely a way for the government to make sure that they get some sort of taxes from you at the source.
They’re trying to simplify things so that down the line you don’t have a huge tax bill. In reality, you might pay zero dollars on that income. If you have no other income and you’re drawing $10,000, you’re most likely going to pay very little tax on that. Alternatively, if you’re in top tax bracket, you’re going to pay 50% on $10,000.
Now there is an option if you’re concerned about paying a large tax bill in April. Let’s say you’re at the top tax bracket, you’re concerned about the withholding tax and you’re also on a tight budget. Good news is that there is the option to ask your financial institution to withhold additional taxes (a higher percentage of taxes).
You must withhold at least the minimum, but you can elect to withhold a higher amount. The minimum being 10% for the first $5000, 20% for $5000 to $15,000 and 30% for anything above $15,000.
All right, so you’ve got the option to withhold the extra taxes. Now that you’ve drawn the extra taxes out, you’re worried you might be in top tax bracket.
The question as to whether you should withhold that tax is one that depends on your cashflow.
If all things being equal and if you’re going to be able to fund the capital for your taxes in a year from now in April, when you’re filing your taxes, then for most people it makes more sense mathematically to withhold the least amount of tax as possible. Reason being is that you get the use of that capital in your hands for six, eight, ten, twelve months.
If I pull out money on January 1st and I paid 10% withholding tax, but I asked them to withhold 50%, I’m now losing 40% of that money for an entire calendar year…
Obviously, the government is happy to have their money in their coffers, but if you can fund it through cashflow, it likely makes a lot more sense to pay it on your income tax.
If you just want to pay it and get it done, that’s no problem. Sometimes that’s simpler.
Now these questions are not necessarily easy ones and you should be talking to an advisor about this.
If you need advice or help with the RRSP withholding tax, please go to speaktorob.com, we’d love to chat more about that with you.
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