If your client is looking to withdraw funds tax-free from his or her RRSP, there are only a handful of options.

The most common methods are through the federal government’s Homebuyers’ Plan and Lifelong Learning Plan. Each allows an RRSP holder to withdraw a maximum of $20,000 from his or her RRSP tax-free. In the case of the HBP, the funds must be spent on buying the planholder’s qualifying first home. Funds taken out under the LLP are for attending a qualifying post-secondary school program full-time.

But if you think these programs amount to a tax-free lunch, think again, says Cynthia Kett, principal of Stewart & Kett Financial Advisors Inc. of Toronto.

“Once people take the money out, they are required to repay it based on a predetermined schedule,” says Kett. “Otherwise, the required payment is added to their taxable income for that year.”

Funds withdrawn from an RRSP under the HBP must be repaid over a period of 15 years, starting the second year after the year of withdrawal.

The LLP requires planholders to repay funds over a span of 10 years; repayment cannot start later than five years after the year of withdrawal. However, repayment can begin sooner, if the planholder isn’t entitled to the full-time education amount for three or more months a year.

For both the HBP and the LLP, the Canada Revenue Agency issues an annual statement of account, which indicates the amount of the next repayment. If planholders miss annual repayments, says Kett, they must include those amounts in their taxable income and pay taxes on them at their marginal tax rates.

“The thing people need to realize with these programs that allow you to take cash out of your RRSP,” she adds, “is that they are tax-deferred — they are not tax-free.”

As when funds are ultimately removed from an RRSP for retirement purposes, they’re taxable.

RRSP holders can withdraw RRSP funds and, in effect, suffer no federal tax consequences by maximizing federal tax credits, says Aurele Courcelles, director of tax and estate planning with Investors Group Inc. in Winnipeg.

For example, once a taxpayer turns 65, the first $2,000 of withdrawals from his or her RRIF can qualify for the federal pension income tax credit. This is calculated by multiplying the RRIF income, up to $2,000, by 15%. Courcelles recommends clients over 65 and in the 15% federal tax bracket (making less than $37,886 in 2008), turn a portion of their RRSPs into RRIFs to take full advantage of the credit, by making their RRIF withdrawals equal to the credit amount.

“[Because] their tax rate and credit rate are both 15%, they don’t pay any federal taxes on that amount,” he says. “But keep in mind that while all provinces also offer a pension income credit, their thresholds are closer to $1,000 than to $2,000.”

That means the tax-free amount clients can withdraw will be less than $2,000, depending on where they live.

For a client with a federal personal income tax rate greater than 15%, Courcelles says, the strategy will still provide tax savings, but to a lesser extent. Regardless, it’s important to keep in mind the credit is non-refundable — if you don’t claim the full amount, you do not get paid back the difference as a refund.

Another credit on the table is the enhanced dividend tax credit, says Courcelles. If clients have significant eligible dividend income, they may be able to withdraw a portion of their RRSPs tax-free because the clients’ federal DTC of 18.97% exceeds his or her federal tax rate in the lowest tax bracket. This excess federal DTC created on the first $37,885 of income may be used to offset RRSP withdrawals.

Let’s take the case of a 55-year-old entrepreneur in Ontario who sells her incorporated business for after-tax proceeds of $875,000 in 2007, but continues to work part-time for the new owner at an annual salary of $12,000. She keeps the sale’s proceeds in her corporation, now a holding company. She buys a portfolio of stocks with the $875,000, which pays dividends of 4% a year, giving her total dividend income of $35,000 for the year.

On her 2008 tax return, her dividend income will be grossed up (multiplied by 1.45) to $50,750. This will be added to her part-time salary of $12,000, giving her a total taxable income of $62,750. Because the federal DTC will give her back $9,625 in credits, her tax credits total $11,311, after the basic personal credit, the employment income credit, and the employment insurance and CPP credits are included.

@page_break@As a result, she has more credits than the $11,203 in federal taxes she owes. She is now free to withdraw about $500 from her RRSP, without paying any federal taxes. Whether or not she withdraws that amount, she still owes provincial taxes. IE