As Canadians are facing economic uncertainty due to COVID-19, their concerns about household debt are paramount. A recent poll found that a significant number of respondents could only cover expenses by going into debt.
Impact of Payment Deferrals and Cashing In Assets
Many Canadians were already facing high levels of debt before the current financial crisis. Even though banks have reduced their credit card interest rates, a high percentage of minimum payments consist of interest charges alone.
For those who have deferred their debt payments because of recent difficult circumstances, the interest is still growing and accumulating every day. So how can you pay off those high credit card balances and interest charges, and lift that overwhelming burden of debt hanging over your head? One of the many options could be cashing in some of your financial assets. Though this would seem like a simple enough solution, let's consider how this would affect your tax situation.
Disadvantages of cashing in an RRSP
If you have investments in a Registered Retirement Savings Plan (RRSP), the money you put into it is deducted from your income for the year, while any income earned on the investment is not taxable while it remains within the RRSP. This is great while you are contributing to an RRSP; however, when you withdraw money from it, the amount you take out is fully taxable, and a percentage is held back to pay for income tax.
For example, if you take out $10,000, approximately 20 percent or more is held for taxes, so you would only receive $8,000 or less. Therefore, if you need to pay off a $10,000 debt, you will need to withdraw at least $12,500. It’s also possible that the taxes held back may not be sufficient to cover your full tax bill, which means you could wind up paying even more when you file your tax return. For example, let's say you withdraw $20,000 from your RRSP. That $20,000 will be considered extra income, so you will need to pay the taxes on it when you file.
Now let's say your taxable income was $40,000 for the year. The approximate rate in Ontario for your federal and provincial taxes combined could be approximately 20 percent, or $8,000. If you withdrew $20,000 from your RRSP, your income jumps to $60,000, moving you into a higher tax bracket where the combined tax rate would be an average of approximately 32 percent. This could result in a whopping $19,200 in taxes. So withdrawing $20,000 from your RRSP could ultimately result in you being on the hook for $11,200 more in taxes. Depending on the amount of the original debt, this additional tax burden could put you in a worse situation.
Advantages of cashing in an RRSP
On the other hand, taking money from an RRSP may be to your advantage if your income is low, or if you are only taking out a small amount. If your income is low enough, or if the amount of money you are withdrawing from your RRSP is small enough, the additional income you are withdrawing from your RRSP might not make your total income jump to a higher tax bracket. For example, if you earn $20,000 per year, your taxes could be about 20 percent or $4,000. If you withdrew $5,000 from your RRSP, your income would be $25,000, and taxed at the same rate of 20 percent or $5,000. So although your taxes would seem to be $1,000 higher, it could actually become less after considering credits and other deductions.
Should I cash in non-RRSP investments to pay off debt?
If you have money in investments other than an RRSP, withdrawing money from them to pay off debt could be advantageous. Why? The interest rate on your debt is probably significantly higher than the rate of return on an investment.
For example, a Guaranteed Investment Certificate (GIC) might earn you an annual rate of return (or interest) of 2 percent, while the annual interest rate of the average credit card is around 19 percent. In other words, you will spend 17 percent more in interest than you will earn on your investment. At today's low interest rates, there is no doubt that you will be saving more money paying off the debt rather than holding a fixed income investment. Even in the case of an unsecured line of credit at 7 percent, you are likely paying more interest on that line of credit than you are earning interest from a fixed income investment. Although there may be taxes on these investments when they are cashed, the extra amount owed may not be all that significant.
Should I cash in equity investments to pay off debt?
For equity investments such as stocks, the return on your investment could be more than your debt charges. However, as we have recently seen, there is no guarantee on your rate of return, which could easily go down as quickly as it goes up. If the value of your investments has significantly decreased due to the recent market drop, you may be tempted to hold onto them until the market recovers.
Under normal circumstances, that would be sage advice for most investors. However, it might be wiser to sell off some of your investments to pay off your debt, as it is likely the return on your investment might currently be less than the interest rate you are paying on your debt. There may also be tax implications from the investment’s gain or loss when you cash it in. For example, if the investment is sold at a loss, this can be claimed against future capital gains. It is important to discuss liquidating your equity investments with a tax professional before considering this as an option.
Should I use my Tax-Free Savings to pay off debt?
When it comes to Tax Free Savings Accounts (TFSAs), there may not be any major personal tax implications if you cash in some of the investment or make a withdrawal; however, if you have invested your limit for the year, you must wait until the following year to redeposit the amount you've withdrawn. As with fixed income and equity investments, the interest paid on any debt is likely going to be higher than the return on your investment. So again, you're better off paying down your debt than stockpiling your money in the bank.
What is the best way for me to pay off my debt?
As you can see, there are many options to repaying your outstanding debt, and although it is wise to start planning now, be sure you have an idea of your current financial situation before moving forward. A recent article in Maclean’s illustrates the serious debt problems Canadians are now facing due to COVID-19. Before you consider cashing in any of your investments, it's important to speak with a tax professional, such as an accountant or financial planner, to examine the pros and cons of each of the options regarding your particular situation.
What are my debt repayment options?
A good starting point would be to contact Credit Canada Debt Solutions and book a free Debt Assessment to discuss your overall financial picture with a certified professional. The appointment is 100 percent free, confidential, and judgement-free. A certified Credit Counsellor will review all of your debt repayment options, including our Debt Consolidation Program (DCP), and work with you to find the best solution that suits your needs. By implementing the right debt repayment plan wisely, you can achieve freedom from stress and worry and become happily debt-free.