Both Canada and the U.S. allow investors to create tax-advantaged savings plans. Unfortunately, neither country recognizes the tax-preferred status of the other country’s plan. When a client holding one of these accounts moves across the border, complications arise.
This isn’t a problem for traditional retirement plans (e.g., private pension plans, RRSPs, and U.S. IRAs), which qualify for tax deferral in the other country under Article XVIII of the Canada-U.S. Tax Treaty. However, no cross-border relief is available for the following tax-advantaged accounts:
- education savings plans (RESPs and U.S. 529 plans);
- savings plans for those with disabilities (RDSPs and U.S. ABLE accounts); and
- tax-exempt savings plans (TFSAs and U.S. Roth IRAs).
In early 2016, the Chartered Professional Accountants of Canada, the American Chamber of Commerce in Canada and the American Institute of CPAs made joint submissions to the Canadian and U.S. governments, asking them to work together to ensure consistent tax treatment across the border. Unfortunately, those submissions haven’t led to changes. Adverse tax consequences and complications remain for these plan holders:
- Americans living in Canada;
- Americans who used to live in Canada and contributed to one of the Canadian plans;
- Canadians living in the U.S.; and
- Canadians who used to live in the U.S. and contributed to one of the U.S. plans.
Let’s take a closer look at the adverse cross-border tax consequences and complications, which include unintended income inclusion, double taxation and complicated additional tax filings.
RESPs and 529 plans
As Canadian advisors know, an RESP permits tax-deferred savings for a child’s post-secondary education. The subscriber contributes to the RESP with after-tax dollars. Income earned on the contributions and government grants paid into the account grow tax-free. When the beneficiary withdraws the funds to pursue post-secondary studies, the accumulated income is taxable in their hands.
A 529 plan, or qualified tuition program, is a U.S. tax-sheltered education savings plan or prepaid tuition plan sponsored by states and educational institutions. Like RESPs, the donor makes contributions to a 529 plan with after-tax dollars and the income grows tax-free. Unlike RESPs, withdrawals from a 529 plan are tax-free to the beneficiary if they are qualified distributions, which are those used to pay educational expenses such as tuition, fees, books and supplies.
The cross-border complications for holders of these accounts are numerous.
Americans who hold RESPs
- Since the IRS considers RESPs to be foreign grantor trusts, the American subscriber must file additional complex IRS forms (3520 and 3520-A) as the trustee of a foreign trust. An American RESP beneficiary must also file form 3520 upon receipt of distributions. Filing these forms late can result in the assessment of substantial penalties.
- The IRS will tax the subscriber on the annual income earned within the plan. This defeats the tax-deferred purpose of the account. Double taxation occurs because the beneficiary will also have to pay Canadian tax at the time of withdrawal on that same income.
- If the RESP holds Canadian or any other non-U.S. mutual funds, ETFs, or REITs, the IRS reclassifies the investments as Passive Foreign Investment Companies (PFICs), which may cause punitive taxation and requires additional onerous IRS disclosures.
Canadians who hold 529 plans
- The CRA doesn’t recognize the tax-free status of 529 plans and taxes annual income earned within the plan.
- The CRA may consider the 529 plan to be a deemed resident trust, which requires the filing of a T3 trust return and additional reporting on form T1135.
RDSPs and ABLE accounts
An RDSP is a Canadian registered plan that permits Canadians with disabilities and their families to save for long-term financial needs on a tax-deferred basis. Just like RESPs, contributions are made with after-tax dollars, they grow tax-free along with the government grants paid into the account, and the beneficiary pays tax on withdrawal.
An ABLE (Achieving a Better Life Experience) account, or 529A plan, is a U.S. tax-exempt savings plan designed to assist individuals diagnosed with significant disabilities before age 26. Just like 529 plans, contributions are made with after-tax dollars, they grow tax-free, and distributions are also tax-free if they are qualified disability expenses.
The cross-border complications with RDSPs and ABLE accounts mirror the complications with RESPs and 529 plans:
- The tax-free status in the home country of annual income earned within the plan is not recognized in the other country. This causes a current income inclusion in the other country and possible double taxation.
- Additional tax reporting burdens occur because of the requirement to file onerous disclosures in the other country on an annual basis. Punitive taxation and added complex reporting requirements occur for U.S. holders of Canadian plans when the underlying investments are considered PFICs.
TFSAs and Roth IRAs
TFSAs allow Canadian residents to earn tax-free income. Contributions are made with after-tax dollars, growth on investment income is tax-free, and withdrawals are also tax-free.
Roth IRAs are similar flexible savings vehicles that allow Americans to make contributions with after-tax dollars and benefit from tax-free growth. Withdrawals from Roth IRAs are also tax-free, but only if made after age 59.5.
Another difference is that all Canadian residents aged 18 and older can make TFSA contributions, regardless of income, but the U.S. phases out Roth IRA contribution eligibility at higher income levels.
Once again, cross-border complications arise.
Americans who hold TFSAs
- The U.S. considers TFSAs to be foreign grantor trusts, resulting in onerous additional IRS filings (forms 3520 and 3520A).
- The U.S. doesn’t recognize the tax-free status of TFSAs, so the American plan holder must pay U.S. tax on annual income, defeating the tax-free purpose of the account.
- Canadian or any non-U.S. mutual funds, ETFs and REITs held within TFSAs are classified as PFICS, which results in additional reporting requirements and possibly punitive taxation.
Canadians who hold Roth IRAs
- There is some relief for Canadian-resident Roth IRA holders under Article XVIII of the Canada-U.S. Treaty. If a Roth IRA owner moves to Canada, the account can maintain its tax-free status if the account holder doesn’t make further contributions after moving. To ensure treaty protection, the account holder must file a one-time election with the CRA before the filing deadline of their Canadian tax return for the year of the move. Any subsequent contributions made to a Roth IRA after moving to Canada causes the treaty protection to be lost, which would make the account taxable in Canada.
- Canadian-resident Roth IRA holders may also have ongoing foreign reporting requirements, including form T1135.
Complications that occur with Canadian and U.S. tax-advantaged accounts often interact with many other cross-border issues, so it’s important for clients to seek advice. In some cases, clients should avoid using certain accounts altogether, while in others, it may be worth the onerous filing obligations if the tax savings outweigh the costs.
Jonah Ravel, B.A., F.Pl., CFP, is a cross-border financial planner with MCA Cross Border Advisors and Matt C. Altro, B. Comm., F.Pl., CFP (Canada), CFP (US), TEP, is president & CEO of MCA Cross Border Advisors.