A growing number of Canadian households are withdrawing their retirement savings before they retire, and this could be harmful to their standard of living later in life, according to Amin Mawani, associate professor of accounting and taxation at York University’s Schulich School of Business.
Speaking at the Canadian Institute of Financial Planners’ Annual National Conference in Niagara Falls on Wednesday, Mawani urged advisors to help clients make smart decisions around making withdrawals from RRSPs prior to retirement.
He pointed out that in certain circumstances, it can be a good idea to make early RRSP withdrawals. For instance, he said the home buyers’ plan is a good option for first-time homebuyers, as long as they’re able to re-deposit the money they’ve withdrawn from their RRSP within the required time frame. Similarly, he supports the lifelong learning plan as an effective way for individuals to fund education, which is an investment in human capital.
Tax planning is another reason that early withdrawals sometimes make sense, since investors can time RRSP withdrawals to shift income from periods when they’re in a high tax bracket to periods when they’re in a lower tax bracket, Mawani said.
But a growing number of Canadians are making RRSP withdrawals for reasons other than these, and the withdrawals are becoming more material as a percentage of individuals’ income, he said. This can substantially hamper their savings in retirement, since individuals do not regain the contribution room after making withdrawals from an RRSP.
“It can significantly impair long-term accumulation,” Mawani said.
One reason that families turn to their retirement savings during their working years is that they need additional income during periods of unemployment or lower income levels, according to Mawani.
“An increasing number of individuals and families are experiencing income shocks and higher variance of earnings — the highs are high, and the lows are low,” he said. “A greater number are tapping into their retirement savings before retirement to finance current consumption.”
Individuals who are more likely to make early withdrawals include lower income Canadians, and those who experience divorce or separation, widowhood, or disability.
It is also particularly common for younger RRSP holders to make withdrawals, since they’re more likely to utilize the homebuyers’ plan, and they tend to have more work disruptions for reasons such as having children or continuing their education.
This is a concern, Mawani said, since younger individuals who make these withdrawals without repaying the funds will end up making a bigger sacrifice in the future, because they’re giving up the opportunity for their savings to compound and grow over a longer time horizon.
“They might perceive the opportunity cost to be small given that retirement is so far away, but it’s actually the greatest, because their benefit of having tax-sheltered savings for 40 years is greater than for someone who is 50, and can only shelter it for 15 more years,” Mawani said.
Mawani suggested that perhaps Canadian policymakers should impose penalties on early withdrawals, in order to deter investors from tapping into their retirement savings. In the United States, for example, a 10% penalty is applied to early withdrawals from 401(k) plans, other than those necessary for medical expenses, tuition fees, or the purchase of a first home.
He also calls for greater financial literacy to educate Canadians on the importance of saving for retirement and the potential tax consequences of making early withdrawals.
Mawani urges advisors to help educate clients on these factors to ensure they’re making smart decisions around pre-retirement withdrawals. For instance, he said advisors should ensure clients know their marginal tax rates, and therefore the price of earning and reporting additional income.
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