Do You Owe Taxes on Money You Borrowed?

In ordinary circumstances, you don’t owe taxes on borrowed money. However, if you borrow from your registered retirement savings plan, you’ll be taxed on the money you borrow, and other penalties may apply.

There are two exceptions:

• With specific limitations, you can borrow from your RRSP to buy a home or to continue your education without paying taxes on the borrowed money.
• First-time buyers can borrow from an RRSP to buy a house.

Status of Borrowed Money

Whether you borrow from a commercial lending institution or a private party, you don’t own that money, which remains the property of the lender. Interest you pay for the loan becomes a taxable gain for the lender. If you make money with the money you’ve borrowed, that’s a different matter. You would then pay taxes on the gain. But whether the capital you used to make the money is yours or borrowed makes no difference in your taxes.

Borrowing From RRSPs

The tax advantages of an RRSP are considerable, but so are the tax penalties for a loan, even if you intend to pay it back. Money borrowed from your RRSP is taxed twice, first through a withholding tax, which for the first $5,000 is 5% in Quebec and 10 percent in other provinces. From $5,001 to $15,000 the rates jump to 10% in Quebec and 20% in other provinces. Above $15,000, the rates are 15% in Quebec and 30% elsewhere.

When you borrow money from an RRSP, you have a limited right to repay it. Borrowing doesn’t change the available contribution headroom in your RRSP account; no matter how much you borrow, your contribution headroom remains the same. If you have maximized your contributions to RRSP when you borrow, you can’t repay it back at all. If you borrow $10,000 from your RRSP when you have $20,000 of available contribution headroom, it drops to $10,000 when you return the borrowed money. You’ve effectively lowered your lifelong contribution limit by $10,000.

Taxes on RRSP Loans

There’s more bad news. At the end of the year, the money you borrow from your RRSP is treated as taxable income and since it’s added to your other income for the year, it’s taxed at your highest marginal rate. The taxes already withheld are deducted from the tax amount owing, but your marginal rate may be as high as 33%.

Sheryne Mecklai, CPA, CA, a tax specialist with Manning Elliott, an accountancy and tax advisory firm in British Columbia, notes, “How and when you draw the money from the the RRSP account makes a difference in how much you’re going to pay in taxes on the money you withdraw. The best time to take money out is (in a tax year) when your income is low.” If you withdraw $10,000 from your RRSP during a year you earned $30,000, for example, you’ll pay approximately $1,500 on the RRSP income. If you earned $150,000, however, that withdrawal will be taxed at a higher rate – $2,900 to be exact.

RRSP Tax Penalty Exceptions

The CRA allows you to borrow up to $35,000 from your RRSP without paying a tax penalty, provided that:

• you use the money to buy a home,
• you are defined as a first-time buyer under CRA rules, and
• you repay the money in fifteen equal yearly installments.

You can also borrow money to go back to school. The maximum you can borrow under the CRA’s Lifelong Learning Plan is $20,000, with a maximum of $10,000 yearly. You can wait up to five years before beginning to repay the money, which must be repaid in 10 years, usually by making equal yearly payments. In both cases, if you fail to repay according to the CRA’s repayment schedule, the borrowed money becomes taxable.

Borrowing in Bankruptcy

The Office of the Superintendent of Bankruptcy Canada states that persons in bankruptcy who continue to borrow money — sometimes for frivolous purposes, such as vacations abroad — may be required to repay some or all of the money before being discharged. If the bankrupt’s borrowings were also illegal attempts to avoid taxes, the OSBC may oppose discharge until some or all of the taxes are paid.

References & Resources

• Canada Revenue Agency: When and How to Make a Repayment
• Sheryne Mecklai, CPA, CA; Manning Elliott LLP, Chartered Accountants; Vancouver, B.C.
• Canada Revenue Agency: Canadian Income Tax Rates for Individuals – Current and Previous Years