If you have clients who worked in the United States and have returned to live in Canada, they may ask you if they should move their U.S. retirement plan to their Canadian RRSP. As an advisor, this can be a great opportunity to add value to your client relationships, but you need to have a good understanding of cross-border rules to ensure that a transfer is done tax-effectively.
If your clients are Canadian residents, they may be able to transfer their U.S. 401k or IRA plan to their Canadian RRSP under subparagraph 60(j)(i) or 60(j)(ii) of the Canadian Income Tax Act (ITA). You can see the full transfer rules in Carol Bezaire’s March 2009 Advisor.ca article titled “U.S. Pensions and RRSP Transfers”.
For clients under the age of 59 ½ , U.S. plan sponsors are required to withhold 10% if there is an early distribution from the plan. This would include cases where a U.S. plan is collapsed in order to transfer it to a Canadian plan.
Until last year, the Canada Revenue Agency (CRA) treated this 10% as a “penalty” and not a “tax”. This differed from how the CRA viewed the standard 15% withholding tax that is believed to apply to lump-sum withdrawals of U.S. retirement plans.
As a result, although your client could normally claim the 15% withholding tax as a foreign tax credit to offset the Canadian tax liability on the withheld amount, the 10% penalty could not be claimed under the same rule. This meant the 10% would be an absolute cost to your client, so many advisors and clients decided to wait until age 59 ½ before re-evaluating the validity of making the transfer.
Interestingly enough, as per the U.S. Internal Revenue Code, Section 72(t) classifies the 10% as a “tax”, not a “penalty”. The CRA upon review, has now changed its interpretation and has decided that the 10% early distribution penalty should indeed be considered a tax that can now be used as a foreign tax credit on your client’s Canadian tax return. This can be a great conversation to have with your clients who are younger than 59 ½ and hold U.S. retirements plans.
As an example, John is a Canadian citizen who worked in the U.S. and built up a 401(k) retirement plan while in the U.S. He returned to Canada and would like to transfer his 401(k) to his RRSP. John is 58 years old and will be subject to the 10% early distribution tax that typically applies when an individual withdraws money from their 401(k) plan prior to 59 ½.
The value of John’s 401k plan is $100,000. Assuming withholding taxes of 15% and a 10% early distribution tax is applied on the transfer, John will have $75,000 to transfer to his RRSP (ignoring exchange rate differences). Of the money that is withheld in the U.S., $15,000 represents withholding tax and $10,000 is the additional tax incurred because of the early distribution.
Under the CRA administrative position, both of these amounts are eligible for the foreign tax credit (FTC). It is important to keep in mind that John must have at least $25,000 in Canadian tax payable in order for him to be able to take full advantage of the FTC. That is, the foreign tax credit should be fully utilized in the year of the transfer in order to recover the U.S. taxes paid. If John does not have sufficient Canadian tax payable in the year of the transfer he will then forfeit all or part of the FTC.
Many clients are interested in consolidating their retirement assets and holding their retirement plans in the country in which they live. Practically speaking, this makes sense for many Canadians with U.S. retirement plans.
From a tax perspective however, the cost of transferring the plans for younger clients, was in the past, simply too great due to the fact that the 10% penalty could not be recovered and therefore represented a true cost to the transfer.
However, CRA’s new position to allow a foreign tax credit on the early distribution penalty opens the door for younger clients to consider transferring their U.S. retirement plan to Canada. As a result, now is a great time to speak with your younger clients about whether their U.S. retirement plans should be transferred and whether the transfer can be done in a tax efficient manner.