Clients who lived and worked in the United States may have accumulated retirement savings in U.S. plans. Or they may have inherited a U.S. plan on the death of a spouse or received a portion of a U.S. plan from a former spouse. As a result, they’re probably considering whether to consolidate the U.S.-based plan with their RRSP.
This article focuses on issues and strategies for Canadian residents who aren’t U.S. citizens, green-card holders or otherwise considered U.S. persons for U.S. tax purposes. Should they transfer their U.S.-based retirement plans — specifically a 401(k) or individual retirement account (IRA) — to Canada?
Maintaining tax-deferred status
Does the plan have to move with the holder to maintain tax-deferred status? The short answer is no. Both the federal Income Tax Act (ITA) and the Canada-U.S. tax treaty provide for continued tax deferral of U.S.-based retirement plans for planholders living in Canada, just the same as if the planholder were living in the U.S.
Canadians who own Roth IRAs — the U.S. equivalent of a TFSA — must file a one-time election to defer tax on their plan balances.
Why move the plan to Canada?
Reasons may include:
- consolidating investment management and advisory services to one country to simplify affairs, save money on professional fees and bring peace of mind;
- mitigating currency risk and the impact of investment restrictions that may be imposed on non-residents; and
- reducing exposure to U.S. estate tax, because U.S.-based retirement plans are considered U.S. situs assets for estate tax purposes. U.S. estate tax is assessed on value, not gain, at the same graduated rates that apply to U.S. persons.
Conditions to meet
The ITA contains special provisions allowing Canadian residents to transfer a U.S.-based retirement plan to an RRSP on a tax-deferred basis, without requiring RRSP contribution room, provided certain conditions are met:
- The amount is transferred as a lump sum.
- In the case of a 401(k) or other employer-sponsored plan, the amount relates to services rendered by the employee, or the employee’s spouse or common-law partner (or former spouse or common-law partner), while that person was a non-resident of Canada.
- The transferor is a Canadian resident for Canadian income tax purposes when the transfer to the RRSP is made, and typically is planning to remain in Canada permanently.
- The amount is fully taxable in Canada for the year of transfer, with an offsetting deduction for the amount transferred to the RRSP.
- To obtain the offsetting deduction for year of transfer, the RRSP contribution must occur within the same year or within 60 days after the end of the year of transfer from the U.S.-based plan.
- The transferred amount can be contributed to only an RRSP, not a spousal RRSP.
- As transfers to RRIFs aren’t allowed, the RRSP contribution can’t be later than Dec. 31 of the calendar year in which the client turns 71. As such, this strategy isn’t available to those over 71.
Amounts in respect of both employee and employer contributions to a 401(k) may be transferred to an RRSP under the conditions described above. Where contributions to the 401(k) were for services rendered while the employee was a resident of Canada, transfers to an RRSP aren’t normally allowed. This rule can catch employees living close to the border who commute to the United States for work off guard.
For IRAs, the transfer conditions above apply, with the following exceptions:
- Only amounts contributed by your client, their spouse or common-law partner (or former spouse or common-law partner) to the IRA can be transferred to their RRSP on a tax-deferred basis without requiring contribution room. Amounts contributed directly to an IRA by the employer would require contribution room.
- There’s no requirement for your client to have been a non-resident of Canada for their IRA contributions to be eligible for transfer to their RRSP.
Steps to transfer a U.S.-based retirement plan to an RRSP
Step 1: Make a lump-sum withdrawal from the U.S.-based retirement plan. The withdrawal would normally be considered U.S.-source income, subject to a 30% U.S. non-resident withholding tax.1 If the withdrawal is the client’s only U.S.-taxable transaction for the year and early withdrawal penalties don’t apply, the withholding tax will satisfy U.S. tax obligations and a U.S. tax return needn’t be filed.
If your client is under age 59½ on withdrawal, they may be subject to a 10% non-refundable early withdrawal penalty. The U.S. plan administrator isn’t responsible for withholding this penalty. The client must file a 1040NR form to calculate and remit the penalty to the IRS.
Step 2: Contribute the Canadian-dollar equivalent of the gross U.S.-dollar lump-sum withdrawal (before withholding taxes and any penalties are applied) to the RRSP. The Canadian-dollar equivalent is calculated based on the exchange rate in effect on the date of transfer. This contribution must be made by the end of the normal RRSP contribution deadline. Plan amounts that don’t qualify under the conditions above may also be contributed provided RRSP contribution room is available.
Step 3: Report the Canadian-dollar equivalent of the gross U.S.-dollar lump-sum withdrawal as income on the Canadian income tax return (T1), as well as the offsetting deductible RRSP contribution. The amount contributed to the RRSP is reported as a “transfer” on Schedule 7 of the return, so as not to require contribution room. The client can offset their overall Canadian tax liability for the year by claiming a foreign tax credit in respect of U.S. tax paid, including the early withdrawal penalty, if incurred.
Note that while you can normally access a lower withholding tax rate (15%) by taking periodic payments from an IRA or 401(k) plan, you wouldn’t be able to contribute those amounts to the RRSP unless you had existing RRSP contribution room. If you inherited a plan from someone other than your spouse or common-law partner, any lump-sum transfer to the RRSP would also require RRSP contribution room. Similarly, contributing Roth IRA proceeds to an RRSP would require RRSP contribution room. A Roth IRA can’t be transferred to a TFSA and vice versa.
Clients should consult with the relinquishing institution and a tax specialist to determine the requirements to initiate foreign pension plan transfers.
Once the client initiates the transfer with the relinquishing institution, the receiving institution will typically require an application form with investment instructions and a statement from the source plan confirming the type of account the client wishes to transfer. An accompanying letter of direction explaining the details of what is intended may be helpful, particularly where the amount on the cheque is different from the plan statement provided.
Upon receipt of funds clearly indicated as foreign pension monies, the receiving institution will issue to the client a contribution receipt under section 60(j) of the ITA.
How is this strategy tax neutral?
Although a tax-deferred rollover from a U.S.-based plan to an RRSP is available, the U.S.-source withholding tax and potential early withdrawal penalties mean that only a portion of the initial lump-sum withdrawal will be available for an RRSP contribution in the year of transfer.
Therefore, if the client would like to transfer the full pre-tax amount in the year of transfer, they’ll need sufficient funds from other sources to top up the RRSP contribution.
If this isn’t done, some taxation in the year of transfer would normally occur.
Further, while U.S. withholding taxes and potential early withdrawal penalties are eligible to be claimed as a foreign tax credit when filing the Canadian tax return, sufficient Canadian income tax liability from other income sources is required to use the foreign tax credit generated by the withdrawal. Neither the deduction room generated by the transfer nor the foreign tax credit generated by the related U.S. tax liability can be carried forward.
What options are there for clients who don’t meet the requirements for a tax-neutral transfer? For starters, they can hold off on transfers until after age 59½ to avoid early withdrawal penalties. Spreading the transfer over more than one year or triggering sufficient taxable income in Canada in the year of transfer to make full use of foreign tax credits can also help make the transfer more tax-efficient.
Advisors should ask clients if their U.S. plans include after-tax contributions.
U.S. retirement plan contributions can be made with after-tax money. While the growth of these after-tax contributions are withdrawn on a taxable basis, the original contributions can be withdrawn tax-free.
Transferring such contributions to an RRSP moves after-tax money into an environment where it will be taxed upon withdrawal, and thus should be considered carefully.
With 401(k)s, the plan administrator tracks the after-tax and pre-tax contributions. With IRAs (including when 401(k)s are rolled over to IRAs), tracking is the individual’s responsibility.
Rebecca Hett, CPA, CGA, TEP, is vice-president, Tax, Retirement and Estate Planning at CI Investments.
1 Plan administrators are normally required to withhold 30% of the taxable amount, unless a tax treaty specifies a different rate. While the Canada-U.S. treaty specifies a 15% withholding tax rate for periodic pension payments, lump-sum withdrawals do not normally benefit from the lower 15% rate. In any event, IRS Form W-8Ben must be on file for a planholder to qualify for the lower treaty rate. Some administrators may withhold the lower rate on lump-sum withdrawals where this form is on file with the understanding that the lump sum is in respect of periodic pension payments. Check with plan administrators for their interpretation of this rule.