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Should you cash in your RRSP to avoid bankruptcy in Canada?

Last week we discussed Credit Cards: The Fast Route to Bankruptcy in Canada and we learned that the vast majority of people who file bankruptcy in Canada owe money on credit cards. Some of those people have money in RRSPs; should they cash out their RRSPs to avoid bankruptcy?

Under current bankruptcy laws in Canada, RRSPs are exempt from seizure by the trustee if you go bankrupt, except to the extent of your contributions in the twelve months prior to bankruptcy. In other words, if you go bankrupt, you only lose the contributions you have made to your RRSP in the twelve months prior to bankruptcy.

(The rules are somewhat more complex than this. For example, if an RRSP is locked in as a result of previous employment, or if there is a life insurance component, it may also be exempt. Consult a bankruptcy trustee to review your specific situation).

This means that in many cases you can declare bankruptcy, eliminate your debts, and not lose your RRSP. What should you do?

Your first option would be to cash in your RRSP and use the proceeds to repay some or all of your debt, thereby avoiding bankruptcy. Here are some thoughts to consider before cashing in an RRSP to repay debt:

First, all withdrawals from an RRSP are taxable in the year you receive them. If you make significant withdrawals, you may bump yourself into a higher tax bracket, leaving a significant tax liability at the end of the year. The bank may with-hold up to 30% on your withdrawal for tax, but if you end up in the 40% or higher tax bracket at the end of the year, you could still have a significant tax liability. So, before cashing in an RRSP, speak to a tax professional to determine exactly what you will owe in tax.

If you are in the 50% tax bracket and you take $50,000 out of your RRSP, you will only net $25,000, so be careful.

Second, cashing in your RRSP to pay only some of your debt may not be a wise move. It all depends on how much debt you have remaining. If you currently have $20,000 in debt and $100,000 in your RRSP, cashing in $25,000 (or whatever is necessary to net $20,000 after tax) is probably a prudent financial decision. You eliminate your debt, and still have money in your RRSP.

However, if you have $100,000 in debts and only $20,000 in your RRSP, cashing in your RRSP and paying the tax still leaves you with significant debt; in that case a consumer proposal or other debt management solution may be more prudent.

Finally, the interest rate you are earning in your RRSP, and the interest you are paying on your debts is also a consideration. If you are earning 1% interest in your RRSP, but you are paying 25% interest on your department store credit card, it may be wise to cash in your RRSP and pay down the high interest debt. Remember that credit card interest is after-tax interest, so it’s very expensive.

There is no one correct answer for everyone. If you have debts, and you have an RRSP, start with our free, instant interactive debt options calculator to review your options, and then consult a bankruptcy trustee to review your specific situation.