It’s not uncommon for Canadians living or working in the U.S. to own U.S.-based individual retirement accounts (IRAs) or qualified retirement plans such as 401(k) plans. A return to Canada may have them wondering: “What do I do with that money?” Last month’s Retirement Resource Centre article, Canadians with U.S. retirement plans: Things to consider before coming home, covered general information to help guide their decision. This article explores specific options:
- Lump sum withdrawal
- Transfer 401(k) money to an IRA; leave the IRA in place
- Consider a Roth IRA
- Leave the balance with the former employer’s 401(k) plan
- Transfer IRA and 401(k) balances to an RRSP
1. Lump sum withdrawal
For Canadian citizens returning from the U.S., a lump sum withdrawal from an IRA or 401(k) may be the right option if they’re:
- at or close to retirement (age 59½ or older),
- returning to Canada permanently,
- holding a relatively small IRA or 401(k) plan, and
- planning to use the entire withdrawal soon after returning to Canada (for example, within a year of returning).
As for taxes:
- Canadian resident plan owners must include this withdrawal as income for Canadian tax purposes.
- If the Canadian citizen is a Canadian (versus U.S.) resident when they make their withdrawal, the withdrawal will be subject to 30% U.S. withholding tax — although the institution holding the account may reduce that rate to 15%. Use of a foreign tax credit could further reduce or eliminate the withholding tax.
- If a Canadian citizen withdraws the money while still a U.S. resident (and before becoming a Canadian resident), the withdrawal may be subject to lower U.S. tax rates.
Plan owners who aren’t close to retiring may want to think twice about using this strategy — even if they could make a withdrawal as a U.S. resident and benefit from lower U.S. tax rates. The loss of continued tax deferral plus annual taxation of investment growth at Canadian tax rates could offset any tax savings realized from withdrawing their IRA or 401(k) money while they’re still subject to the U.S. tax system.
2. Transfer 401(k) money to an IRA; Leave the IRA in place
Transferring the proceeds of a 401(k) to an IRA is common among U.S. citizens and residents when they leave an employer. It may also be a good option for Canadians who plan on returning to the U.S.
- continued tax-deferred growth potential,
- consolidation of assets into one account,
- flexible withdrawal and beneficiary options,
- the ability to ‘stretch’ IRA income across multiple generations, and
- in most cases, more investment choices than 401(k)s.
This type of transfer can also allow non-spouse beneficiaries to take advantage of continued tax deferral if the plan owner’s 401(k) plan doesn’t.
But differing views among U.S. investment brokerage firms (stemming from different interpretations of U.S. securities laws) may pose problems. While some firms allow non-U.S. residents to own IRAs with securities such as stocks, bonds and mutual funds, others don’t. And those that do are entitled to change their view.
Given these issues, Canadians may be better off with IRAs invested in non-securities like daily interest accounts, certificates of deposit (CDs — the U.S. equivalent of a guaranteed investment certificate) and fixed interest deferred annuities. If you have clients considering this option, encourage them to check first with the institution that will maintain the IRA.
3. Consider a roth IRA
Convert a traditional IRA to a Roth IRA – This option is available only while a Canadian citizen is still a resident of the United States. Anyone who owns a traditional IRA can convert it to a Roth IRA1 through a single transaction or series of transactions. An exception involves the required minimum distributions (RMDs) you must take from your traditional IRA for years including and after turning age 70½ — RMDs cannot be converted to a Roth IRA. IRA withdrawals are treated as income in the year withdrawn, unless they represent non-deductible contributions. Unlike registered retirement savings plans (RRSPs), deductibility for IRA contributions starts being reduced once certain income levels are crossed, until at higher income levels, there’s no deductibility for the contribution. Once converted, and as long as all Roth IRA rules are followed, there’s never any tax on withdrawals from or growth in a Roth IRA.
When a plan owner dies, a surviving spouse beneficiary can treat the Roth IRA as their own, or delay distributions until the year the deceased would have reached age 70½. Non-spouse beneficiaries must take Roth IRA distributions as described above (5-year distribution period, or over their life or life expectancy). There’s no income tax on the amount withdrawn although there’s a 50% penalty tax for missed withdrawals.
Transfer tax-deferred 401(k) assets to a designated Roth account in the 401(k) – Like the Roth IRA conversion, this option is available only while a Canadian citizen is still a resident of the United States. 401(k) plans may include a designated Roth account with many of the tax features offered by Roth IRAs.
Roth IRAs are similar to tax-free savings accounts (TFSAs). Under U.S. tax law, contributions to a Roth IRA aren’t deductible. However, withdrawals made after age 59½ (and 5 years after the tax year that the original Roth contribution was made) are tax-free.
- Employee contributions to a designated Roth account aren’t deductible but plan assets grow tax-free.
- Withdrawals aren’t taxed as long as:
- the plan member is over age 59½, and
- at least 5 years have passed since the tax year that the original designated Roth account contribution was made.
- 401(k) contribution room stays the same, whether contributions go to the designated Roth account or pre-tax deferral account.2
Under the Canada-U.S. tax treaty, Roth IRAs and Roth 401(k) plans enjoy continued tax deferral and tax-free withdrawals, the same as they do under U.S. law.
4. Leave the balance with the former employer’s 401(K) plan
This option is offered by many 401(k) plans and may be a good choice for Canadians who expect to return to the U.S. permanently. Among the advantages (many of which also apply to IRAs):
- 401(k) plan RMDs are lower than registered retirement income fund (RRIF) minimum formula distributions for plan owners age 72 and over. However, if the plan owner bases their RRIF minimum formula withdrawals on their younger spouse’s age, a RRIF minimum formula withdrawal could be lower than an RMD withdrawal. It depends on the difference between the spouses’ ages.
Plan owner age RRIF minimum formula RMD withdrawal 72 5.40% 3.91% 82 7.38% 5.85% 89 10.99% 8.33%
- There’s no requirement to convert from a retirement savings plan to a retirement income plan. This eliminates the risk of the entire IRA or 401(k) plan balance being forced into income in the year after the plan owner turns 70½, if they don’t act in time. There is, however, a 50% penalty tax on missed RMD withdrawals.
- With the low U.S. withholding tax rate (15% on pension and annuity payments), it may be possible to use the foreign tax credit to entirely offset the U.S. withholding tax on IRA and 401(k) withdrawals.
5. Transfer IRA and 401(k) balances to an RRSP
Anyone who expects to remain in Canada permanently may wish to move their IRA and 401(k) money to an RRSP. Two provisions in the Income Tax Act (ITA) govern these types of transfers:
- ITA paragraph 60(j)(i) governs transfers to an RRSP from ‘pension plans’ that aren’t registered plans, and to which the owner made contributions while a non-resident of Canada. The Canada Revenue Agency (CRA) considers a U.S. 401(k) to be a ‘pension plan’ under ITA paragraph 60(j)(i).3
- ITA paragraph 60(j)(ii) governs transfers from an IRA to an RRSP. According to this provision:
- Only lump sum amounts (not periodic payments) contributed by the plan owner or spouse to an IRA may be transferred to the plan owner’s RRSP.
- Technically, employer contributions to the plan owner’s IRA may not be transferred to an RRSP unless the plan owner has enough existing RRSP contributing room to accept the employer contributions.4 But according to the CRA, when someone transfers a 401(k) plan balance to an IRA, the amount transferred will be treated as having been derived from contributions made by the taxpayer or their spouse or common-law partner.5
In both cases:
- When all rules are satisfied and with proper planning, a transfer from an IRA or 401(k) to an RRSP may occur on a tax-neutral basis without using any existing RRSP contributing room.
- Plan owners will need to include the lump sum withdrawal from the IRA or 401(k) in income for Canadian income tax purposes. A deduction for contributing the money to the RRSP will eliminate the tax. The contribution won’t use existing RRSP contributing room. And while U.S. withholding tax will be taken from the withdrawal, the plan owner can use a foreign tax credit to reduce or eliminate their Canadian tax bill by the same amount.
Did you know?
While Canadian law allows a tax-neutral transfer of IRA and 401(k) money to an RRSP,6 U.S. law doesn’t allow a transfer of RRSP or RRIF money to an IRA.7 Plan owners who believe they’ll return to the U.S. permanently may wish to leave their plans alone and elect to defer Canadian taxation each year on those plans.
All these options require careful consideration, based on individual circumstances. Encourage your clients to consult a tax advisor well-versed in IRAs and 401(k)s before initiating any type of transfer or conversion.
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).
You might also like…
- What Canadian clients need to know about U.S. taxes – part 1
- What Canadian clients need to know about U.S. taxes – part 2
1 IRS Publication 590-A, “Contributions to Individual Retirement Arrangements,” available at https://www.irs.gov/pub/irs-pdf/p590a.pdf.
2 $18,000 in 2016 plus $6,000 for employees age 50 and over.
3 CRA Document 2004-0065161E5, dated June 1, 2004 and CRA Document 2004-0071271E5, dated July 13, 2004.
4 The ITA doesn’t specifically exclude employer contributions to an IRA from transfer to an RRSP. Rather, ITA subparagraph 60(j)(ii) applies only to transfers of an ‘eligible amount’. ITA section 60.01 defines an ‘eligible amount’ as an amount received from a ‘foreign retirement arrangement’ except for the part of the arrangement contributed by ‘a person other than the taxpayer or the taxpayer’s spouse or common-law partner or former spouse or common-law partner.’ Since amounts contributed by an employer would fall within the ‘other than’ part of the definition, employer contributions to an IRA may not be transferred on a tax-neutral basis to an RRSP. ITA subsection 248(1) and Regulation 6803 define a ‘foreign retirement arrangement’ as an arrangement to which IRC subsection 408(a), (b) or (h) applies. These sections all refer to IRAs.
5 CRA Document 2004-0071271E5, dated July 13, 2004.
6 This article uses the term ‘tax-neutral’ to describe the transfer from an IRA or 401(k) plan to an RRSP because tax consequences may be avoided only with proper planning – not because the transaction is, in and of itself, tax-free.
7 Private Letter Ruling 9833020, dated August 14, 1998. Private letter rulings are binding only on the IRS and the taxpayer who requested the ruling. However, like the CRA’s advance income tax rulings, they provide an indication of the IRS’ thinking on a particular tax topic.