Withdrawing money from your Registered Rertirement Savings Plans can be extremely painful from a tax perspective but it doesn’t have to be. The whole idea of winning at the RRSP game is to put money into the RRSP when you are in a higher marginal tax rate and to withdraw the money out of the RRSP at a lower marginal tax rate.

For example, Let’s say Liz makes $85,000 at the time she contributes to the RRSP putting her in a 36% marginal tax rate. If she contributes $5000 to the RRSP, she will get an $1800 tax refund from the government. If we fast-forward Liz into retirement when she is in the lowest tax bracket (25%), withdrawing that $5000 would trigger a tax bill of $1250. Math suggests this is a pretty good deal. I like to think of it in terms of a loan. When Liz buys and RRSP, it’s kind of like the government lending her $1800. That loan has to be paid back in the future when she withdraws the money out of the RRSP. In this case, because she has a lower marginal tax rate when she takes the money out, she only has to pay back $1250 of the $1800.

This is how RRSPs should be used. Not only does Liz pay back only $1250 of the $1800 government loan, but she got to use the $1800 of government money for all those years and get tax deferred compounding on the investment. This is precisely why RRSPs are so beneficial from a tax planning perspective.

If she withdraws the $5000 while she is still working like 40% of Canadians, she would pay $1800 in tax negating any tax benefit she would have gotten in the first place.

Most people buy RRSPs because of the immediate tax deduction but to truly understand the tax benefit of RRSPs, it is very important to be aware of how much tax you have to pay when you are planning to take the money out. In most cases, people are in a lower tax bracket in retirement than while they were working. Thus, waiting till retirement to take money out of the RRSP is what RRSPs were designed for.

There are three circumstances I can think of when it might be a good idea to take money out of an RRSP before retirement:

1. Withdrawals under the Home Buyers Plan. Under the Home Buyers Plan, you can withdraw up to $25,000 from your RRSP towards the purchase of your first home. Studies have shown that home ownership is a very good wealth contributor because over time, it is an appreciating asset.
2. Withdrawals for Life long learning. Similar to the Home Buyer Plan, you can withdraw up to $20,000 for for the purpose of training or education in a qualifying educational program at a designated educational institution. The whole idea behind investing in your education is to invest in your ability to increase your potential earning power. That seem like a pretty good investment to me.
3. Withdrawals when you are in a lower tax bracket. RRSPs were not really designed for withdrawals while working but it can work in situations where you have the opportunity to withdraw the money when you are in a lower tax bracket than when you first contributed into the RRSP.

Be smart when it comes to making RRSP decisions. It’s not just about saving money in tax through the deduction. The real winners know it about when you put the money into the RRSP and also when you take the money out.