You’ll recall that withdrawals from your RRSP are normally included as income in the year that you make the withdrawals (save for a few exceptions). If you happen to be in a low income year and have the need to make a withdrawal from your RRSP, then it might make sense to space out your withdrawals such that you minimize the withholding tax that your RRSP issuer will remit to the Government on your behalf…
For example we know that your RRSP issuer will withhold the following percentages if you ask to make a withdrawal from your RRSP:
Withdrawal of up to $5,000 = 10% Withheld
Withdrawal of $5,001 – $15,000 = 20% Withheld
Withdrawal of $15,001 and above = 30% Withheld
So let’s say you are in a year where you have NO income from work and you decide that in order to pay your bills you will have to withdraw approximately $17,500 from your RRSP. In Ontario, someone with a taxable income of $17,500 would pay about $1,869 in income tax for the year (according to the trusty online 2007 tax calculators at Ernst & Young’s website).
Well, according to the chart up above, if you made a withdrawal of $17,500 from an RRSP account in one transaction – your RRSP issuer is obligated to withhold 30% of that $17,500 – or in other words: $5,250. Therefore, you would have to wait until you filed your taxes for 2007 before you would receive a tax refund of $3,381 (which is equal to $5,250 taxes paid minus $1,869 taxes owing). Would you loan any money to the government interest-free if you could avoid it? Well, most people wouldn’t – and here is one way to go about it:
You could space out your withdrawals so that instead of having one lump sum withdrawal of $17,500, you could structure it as four separate withdrawals of $4,375. In this case, each withdrawal would only be subject to a withholding amount of 10%, or $437.50 per withdrawal. $437.50 multiplied by four withdrawals equals $1,750. So in this case, you would actually be borrowing $119 from the Government interest-free until you filed your taxes ($1,869 taxes owing for the year minus $1,750 paid in the form of withholding tax).
One thing to note is that if you ask your RRSP issuer for $5,000 NET (meaning that is how much money will be transferred to your bank account AFTER deducting withholding taxes) then that puts you in the $5,001 – $15,000 withdrawal range, since in order to provide you with $5,000 net, they will need to de-register $6,200 GROSS (20% of $6,250 = $1,250 withheld).
Additionally, if you make a withdrawal from your RRSP in a higher income year, and the withdrawal is for under $5,000 – your RRSP issuer may not withhold ENOUGH tax and you will have a higher tax bill come tax time than you might have otherwise thought.
For example, let us say you are in the top tax bracket in Ontario (46.41%) and for whatever reason, you decide to make a withdrawal of $5,000 GROSS from your RRSP account. Your RRSP issuer will withhold 10%, or $500, from the gross amount to leave you with $4,500. Therefore you have paid $500 in income tax in advance for this withdrawal. HOWEVER, as a top-tax bracket investor, you will actually owe a total of $2,320.50 in income tax on this withdrawal. Since you have only paid $500 “in advance”, you will be on the hook for an additional $1,820.50 come tax time.
And finally, I know that some RRSP issuers will not allow you to take advantage of this loophole of making separate withdrawal requests if they are too close together. Well actually, they will let you make the requests and they will process them, but they will add up the total amount of the separate requests and have a balloon withholding tax amount on the last withdrawal. One way to avoid this would be to make withdrawal requests from separate RRSP accounts or RRSP issuers if you have more than one.