Canadians who’ve lived and worked in the U.S. may own individual retirement accounts (IRAs) and retirement plans such as 401(k)s. A return to Canada may have them wondering:
- Should I leave the money where it is?
- Can I move the money to a registered retirement savings plan (RRSP)?
- What are the tax implications?
- What else should I know?
This article, the first in a 2-part series, highlights things to know before deciding what to do with a U.S. retirement plan. Our second article will cover the options your clients can consider.
About IRAs and 401(k)s
IRAs are similar to individual RRSPs. A Canadian may acquire an IRA by:
- contributing to an IRA (similar to contributing to an RRSP) — generally they must be living and working in the United States,
- transferring an employer-sponsored qualified plan balance to an IRA when employment ends (the U.S. doesn’t have the equivalent of a locked-in RRSP), or
- acquiring some or all of their spouse’s IRA because of divorce or the spouse’s death.
Like RRSPs, IRA balances grow tax deferred. Withdrawals are taxed as income.
401(k) plans are sponsored by employers and are similar to defined contribution pension plans:
- Contributions are deducted from an employee’s pay (before tax deductions).
- These contributions are invested into funds offered by the plan.
- Some employers match or supplement employee contributions.
Like IRAs, 401(k) plan balances grow tax deferred; withdrawals are taxed.
Continued tax deferral – Under the Canada–U.S. Income Tax Convention (the treaty), tax deferral of IRA, 401(k) and Roth IRA1 balances can continue when someone returns to Canada.2 But it’s not automatic. Canadian plan owners must file an election each year with their Canadian tax return to defer tax on their IRA, Roth IRA and 401(k) plan balances.3
Did you know?
The name ‘401(k)’ is based on the section of the Internal Revenue Code that governs these plans.
Lump-sum withdrawals – When a non-U.S. resident withdraws a lump sum from an IRA or 401(k), the IRS requires the financial institution disbursing the funds to withhold 30% of the taxable amount, unless a tax treaty specifies a different rate4 (periodic pension payments, for example, may be taxed at 15%).
10% penalty tax – For plan owners under age 59½, an IRA or 401(k) withdrawal could trigger an additional 10% premature withdrawal (or penalty) tax on the taxable amount.5 It’s not clear, however, if this tax applies to non-residents. Two sections in the Internal Revenue Code (IRC) differ on this issue:
- Section 72 describes the tax treatment for IRA and qualified plan withdrawals, imposing a 10% penalty tax on early withdrawals (in the absence of an exception).
- Section 1441 describes the tax treatment for distribution of U.S.-source income to non-residents, and imposes only withholding tax.
One approach is to follow the IRS’s rules for U.S. citizens and residents. If a U.S. citizen or resident makes a premature withdrawal from a qualified plan or IRA, the institution involved only reports that a premature withdrawal occurred and if there’s a known exception to the penalty tax. It doesn’t calculate any tax owing or withhold any money because of a penalty tax. It’s up to the taxpayer to calculate the penalty tax on their tax return, file it and pay any extra tax owing.
Canadian tax treatment of IRA or 401(k) withdrawals – Under U.S. law, IRA and 401(k) withdrawals made by U.S. citizens or residents are taxed as income in the year of withdrawal, even if growth in the plan came from dividends or capital gains. The taxable withdrawal is the gross distribution, calculated before any withholding taxes, penalty taxes, surrender charges or fees are applied. Canadian residents must treat IRA and 401(k) withdrawals the same way for Canadian tax purposes.6
Encourage Canadian 401(k) plan owners with employer shares in their plan to talk with a tax advisor before transferring anything to an IRA or RRSP. A 401(k) plan administrator can only transfer money – not shares – and will have to sell the shares to make the requested transfer. Under U.S. tax law, employer shares can be distributed as shares, with only the adjusted cost base subject to tax on distribution. Any capital gains remain tax deferred until the shares are disposed of. It’s not entirely clear if Canadians are entitled to this potentially valuable tax treatment but if they are, it would be lost if funds were transferred to an IRA or RRSP.
RRSP contribution – A Canadian resident who has an IRA or 401(k) plan withdrawn may contribute the withdrawal amount to their RRSP without using existing RRSP contributing room, as long as they do so no later than 60 days after the end of the year the withdrawal was made. The deduction for the RRSP contribution should offset any Canadian tax imposed on the withdrawal.
Foreign tax credit – The RRSP contribution won’t eliminate the U.S. withholding tax, though. For that, a Canadian resident will need to claim a foreign tax credit.7 Under section 126 of the Income Tax Act (ITA) a foreign tax credit is allowed as a ‘tax credit for foreign income or profit taxes paid by a resident of Canada … as a deduction from Canadian tax otherwise payable on that foreign income’ (see IT-270R).8 Even though the RRSP contribution eliminates the Canadian tax liability, the CRA still allows the foreign tax credit to reduce or eliminate the U.S. withholding tax.9
RMDs during a plan owner’s life – Tax deferral doesn’t last forever — on either side of the border. IRA and 401(k) required minimum distributions (RMDs) must begin by the end of the year the plan owner reaches age 70½. RMDs are similar to minimum formula distributions in Canada. There’s no requirement to transfer an IRA or 401(k) balance to an income vehicle like a registered retirement income fund (RRIF). Instead, plan owners withdraw the RMD (or more) by December 31 of the year they turn 70½ and by December 31 of each year after that.
This article is based on a reference guide authored by Stuart L. Dollar, Director, Tax and Insurance Planning, Sun Life Financial, Strategies for Canadians with U.S. retirement plans (July 2015).
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1 Roth IRAs are similar to Canadian tax-free savings accounts (TFSAs). Roth IRA contributions may not be deducted from income, but grow tax-free. Roth IRA withdrawals are tax-free as long as all withdrawal rules are followed. Under current law, Roth IRA balances may not be transferred to a TFSA or vice versa.
2 Treaty, Article XVIII. Paragraph 81(1)(r) of the Income Tax Act (ITA) governs tax deferral of IRAs owned by Canadian residents. 401(k) plans owned by Canadian residents are treated as ‘U.S. pension plans’ and are therefore ‘employee benefit plans’ under ITA subsection 248(1) (see CRA Document 9410515, dated September 28, 1994). As long as an election to defer tax is filed, income isn’t recognized from such plans until a withdrawal is taken.
3 The Canada Revenue Agency (CRA) provides no form or published guidance for plan owners wanting to make this election except for Roth IRAs. For information about Roth IRAs, see Income Tax Technical News No. 43, September 24, 2010. For an archived version, visit http://www.cra-arc.gc.ca/E/pub/tp/itnews-43/it-news-43-e.pdf. Although the CRA’s interpretations of tax law can help taxpayers understand their obligations, these interpretations aren’t legally binding on the CRA, and may change at any time. References to CRA publications and administrative decisions are included to help understand the CRA’s thinking on the issues related to this article.
4 Internal Revenue Code (IRC), section 1441. Also see ‘IRS Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities’ available at http://www.irs.gov/pub/irs-pdf/p515.pdf, pages 17 and 20.
5 Under Internal Revenue Code (IRC), section 72(t)
6 401(k) plan distributions are included in Canadian taxable income under ITA subparagraph 56(1)(a)(i); IRA distributions are included under ITA clause 56(1)(a)(i)(C.1): CRA Document 2004-0071271E5, dated July 13, 2004
7 Income Tax Act (ITA) section 126. See also the CRA’s Income Tax Folio, S5-F2-C1: Foreign Tax Credit, available at http://www.cra-arc.gc.ca/tx/tchncl/ncmtx/fls/s5/f2/s5-f2-c1-eng.html
9 CRA Document 9634955, dated March 5, 1997