One of the advantages of filing a consumer proposal is that your monthly payments are often less than they might be in a bankruptcy. This means you can use your extra cash flow any way you like, including continuing to make contributions to an RRSP. This might be particularly attractive to you if your employer matches your RRSP contributions. But what if you’ve built up some savings in your RRSP, enough to pay off your proposal early?
You are not required to cash in your RRSP, it’s your choice, but the question is whether or not that’s a good choice. Let’s consider an example:
Joe Smith filed a consumer proposal where he agreed to pay $300 per month for 60 months for a total of $18,000 to eliminate $50,000 in unsecured debts. At the time he had an RRSP valued at $5,000 including his last year’s contributions which, because he filed a consumer proposal, he was able to keep.
Joe has been making his payments for 30 months and now he only has 20 months, or $6,000 remaining to pay on his proposal. During this time he also continued to contribute to his RRSP, as did his employer, and he how a total of $8,000 in his RRSP.
Should Joe cash in his RRSP and pay off his proposal?
As full disclosure, as a consumer proposal administrator I get paid a percentage (based on a government set tariff) of what Joe pays and we distribute to the creditors. The faster he pays, the faster I get paid, however it does not change what I get paid.
Of course the question is not what’s best for me; it’s what is best for Joe. Let’s consider the options:
Cash in RRSP and Pay Off Proposal Early
If Joe cashes in his RRSP and pays off the proposal, the proposal is finished. He has no further proposal payments, and therefore nothing can go wrong. He has no risk of missing payments and having his proposal annulled for non-payment. All is good.
Even better, once the proposal is finished Joe can devote all of his resources to repairing his credit. He can take the $300 per month he was using to fund the proposal to start a savings plan, replace his RRSP, or perhaps to build up a down payment for a car or house purchase. By completing the proposal early, Joe can get an early start on rebuilding his credit.
However, if Joe cashes in his RRSP, he is required to pay tax on the withdrawal. If Joe is in the 30% marginal tax bracket and cashes out his $8,000 RRSP he will pay 30% in tax, or $2,400, so Joe only nets $5,600, which is not quite enough to fully pay out the proposal.
Joe must decide if it’s worth it to pay the tax on the withdrawal to pay off the proposal early.
Don’t Cash in RRSP, Continue Regular Proposal Payments
By not cashing in the RRSP Joe can’t pay off his proposal early, but he also doesn’t lose $2,400 to taxes. By keeping his RRSP his investment continues to increase, tax free. As a result, in 20 months, Joe will have a paid off proposal and $8,000 (plus further increases from investment gains) in his RRSP.
Only Joe can decide which option is preferable.
Some Considerations When Making The “Cash RRSP or Not” Decision
I would advise Joe to consider the following questions:
- How important is it to immediately begin rebuilding credit? If Joe wants to buy a house in two or three years, paying off the proposal early is a definite advantage. Most mortgage lenders will give you preferred rates only after two years have elapsed since you completed your proposal. In that case paying it off early may be worth it. However, if Joe has no plans to borrow in the near future, he may be better to continue as is.
- Joe has an RRSP through his employer. If he withdraws his contributions, will the employer stop matching his contributions for a period of time? Are there any penalties? Many employer sponsored RRSP plans have a rule that if you make a withdrawal the employer will not contribute for a year, so cashing in the RRSP may cost Joe a lot more than just the taxes he will pay; he also loses a year’s worth of employer contributions.
- How close is Joe to retirement? The closer to retirement, the less you may want to cash in your RRSP.
- What is the RRSP earning and is the investment cashable? If Joe’s RRSP is invested in stocks that are losing money, cashing in the RRSP may be a good idea. However, if the RRSP is earning consistently good returns or early cash-in has a cost, keeping the investment may be prudent.
As you can see, whether or not to cash in an RRSP during a proposal is a difficult decision, and the answer will be different depending on your circumstances. Before making a decision, consult your investment advisor and your consumer proposal administrator to help you crunch the numbers and make an informed decision.