Tax considerations: Canadian tax treatment of U.S. retirement plans

James Smeaton, CPA, CA, Senior Wealth Consultant

Tax Considerations is a series of articles designed to help you navigate the complexities of cross-border taxes. See Tax considerations: Americans living in Canada for information to help you understand the tax requirements of U.S. and Canadian tax systems.

If you're a Canadian who has worked in the U.S. or another foreign country, or if you’re a newcomer to Canada, you may have built up a foreign retirement account. Some examples of U.S. retirement accounts include an Individual Retirement Account (IRA), 401(k), 403(b), Roth IRA or other pension plans. It's also possible that you have inherited a U.S. retirement plan from a loved one. Now that you have returned to Canada you may be wondering what options are available to you regarding these accounts, how you can avoid high fees, or if moving your money is the right thing to do. While a financial advisor can help you make the best decision and a plan, let's get started by learning more about retirement plans and some of your options.

The information presented below is intended for non-U.S. citizens and individuals who do not have a Green Card.

U.S. retirement plans

The U.S., like Canada, has many retirement plans that are intended to offer tax advantages for retirement savings. Some of the well-known U.S. retirement plans include:

401(k) or 403(b) plan

401(k) and 403(b) plans were designed to allow people to save money, grow investments and defer tax until they are ready to withdraw their funds. These plans are:

• Administered by an employer and funded by both employer and employee contributions. The key difference between the two plans is that a 401(k) plan is offered to employees of for-profit companies, whereas a 403(b) plan is offered to employees of non-profit organizations, universities, and government entities.
• Covered under the provisions of the Canada – U.S. tax treaty. If you’re a Canadian tax resident with a 401(k) or 403(b) plan, your funds should remain tax deferred for both Canadian and U.S. purposes until you withdraw them. Under U.S. rules, distributions have to start when the account holder reaches the age of 73 and a 10% early withdrawal penalty may apply if distributions are taken before the account holder reaches age 59.5 (59 and one-half years of age).

Individual Retirement Account (IRA)

An IRA shares some characteristics of a 401(k) or 403(b) plan except that it is not employer sponsored. It is an individual plan set up through a retail brokerage firm, similar to a Canadian Registered Retirement Savings Plan (RRSP). Both an IRA and an RRSP were designed to allow people to save money, grow investments and defer tax until they are ready to withdraw their funds. An IRA:

• Allows the account holder to have more say regarding the investments in the account as it is not employer administered.
• May allow a 401(k) or 403(b) to be rolled into it without triggering a taxable event in Canada or in the U.S.
• Are covered under the Canada – U.S. tax treaty, so funds in the account may remain tax deferred for both Canadian and U.S. purposes until a distribution is taken. Under U.S. rules, distributions have to start when the account holder reaches the age of 73 and a 10% early withdrawal penalty may apply if distributions are taken before the account holder reaches age 59.5.

Roth IRA

A Roth IRA is similar to Canada's Tax-Free Savings Account. Contributions to a Roth IRA are not tax deductible, income can be earned in the Roth IRA, and withdrawals from the Roth IRA should be tax free.

• Roth IRAs are not automatically treated as a foreign pension under the Canada – U.S. tax treaty. If you are an owner of a Roth IRA and want it treated like a pension plan under the Canada – U.S. tax treaty, a special election must be made by April 30th of the year following your Canadian residency start date and sent at the same time as your Canadian tax return. 
• To elect to have your Roth IRA treated as a pension, you must make the special election with Canadian Competent Authority Services. Once this election is in place, no contributions can be made to the Roth IRA as a Canadian resident, but any withdrawals from the Roth IRA should not be subject to Canadian tax provided they are not taxable in the U.S. 
• Under U.S. rules there is no minimum age when an account holder must withdraw funds from a Roth IRA, however, if funds are taken out before age 59.5, a 10% early withdrawal penalty may apply.

Canadian tax on U.S. retirement plans

Canadian tax residents are taxable by Canada on their global income which includes distributions from U.S. retirement plans. So, funds in an IRA, 401(k) and 403(b) may remain tax deferred until a distribution is taken from the plan. Once a distribution is taken, it must be claimed as income when filing your Canadian tax return in the tax year it was distributed.

• For non-U.S. persons (not a U.S. citizen and does not hold a Green Card), the income may be subject to a 30% U.S. withholding which may be reduced to 15% under the Canada-U.S. tax treaty.
   

  Withholding Tax The amount of money deducted and remitted to the IRS by an Individual Retirement Account (IRA) custodian or financial institution when a nonresident alien takes money out of certain U.S. retirement plans such as a 401(k), 403(b) or IRA.

U.S. taxes paid may be able to be claimed as a foreign tax credit in Canada to reduce the risk of double taxation. Withdrawals from a Roth IRA, with a proper treaty election in place, do not need to be included in Canadian income provided the withdrawal was not taxable in the U.S.

Pension splitting

In Canada, an election can be made to split eligible pension income between spouses. This means that certain types of pension income can be allocated to the spouse who has a lower overall income and be taxed at that spouse's lower tax rate. Certain foreign pension distributions may be eligible for pension splitting in Canada. Distributions from a U.S. IRA are not considered eligible pension income for pension splitting purposes but distributions from a 401(k) or 403(b) may be considered eligible pension income for pension splitting purposes.

U.S. retirement plan options after becoming a Canadian resident

Now that you have returned to Canada you may be wondering what options are available to Canadian residents with U.S. retirement plans. In this next section we dive into not only your options, but the costs and benefits associated with each.

Example

Geoff is aged 60 and he lived and worked in the U.S. for 10 years. He is not a U.S. citizen or Green Card holder, he has now returned to Canada, and has re-established Canadian tax residency.

While Geoff was employed in the U.S., he was a non-resident of Canada and participated in a 401(k) plan which he rolled over to an IRA. His IRA balance is $100,000. Geoff would like to close the IRA in the U.S. and transfer it to an RRSP account.

In Canada, Geoff is employed and earns $150,000 salary per year.

To transfer the IRA to an RRSP, Geoff will have to withdraw the $100,000 from his IRA in the U.S. If Geoff does, 30% (or $30,000) would be withheld by the plan administrator and remitted to the IRS to satisfy his U.S. tax obligation on the withdrawal, leaving Geoff with $70,000 to deposit in his RRSP.

On the Canadian side, and assuming the foreign exchange rate is 1 to 1 for simplicity, Geoff will need to report the $100,000 withdrawn from his IRA as income but can take a corresponding deduction if he deposits $100.000 to his RRSP. This means, he will need to top up the RRSP contribution with $30,000 of his own funds to compensate for the U.S. withholding tax.

As a result, on his Canadian tax return, his taxable income will be $150,000 ($150k salary + $100K IRA income less $100k RRSP contribution). In Ontario, he will owe approximately $42,705 in taxes. Geoff can also claim a foreign tax credit for the $30,000 U.S. withholding, lowering what he owes the Canadian Revenue Agency to $12,705. In doing so, Geoff has avoided being double taxed.

RRSP as follows (assume 1:1 foreign exchange rate for illustration purposes):

Example Takeaway

Careful analysis needs to be done prior to withdrawing from a U.S. retirement plan and transferring to an RRSP to ensure that it can be done on a tax neutral basis. Since the withdrawal from the U.S. plan is net of withholding taxes, but the full withdrawal amount is included in income for Canadian purposes, the RRSP contribution would need to be topped up with additional funds to ensure that the income from the U.S. retirement withdrawal is fully offset. Also, to claim a full foreign tax credit in Canada, there would need to be sufficient sources of other income to utilize the foreign tax credit as they cannot be carried forward to future years in Canada.

Options for inherited U.S. retirement plans

It is important to note the tax treatment differences between U.S. and Canadian retirement plans at death.

• In Canada, the RRSP holder is taxed at death unless a spouse or financially dependent minor child or grandchild is named as a beneficiary.
• In the U.S., the retirement plan is taxable in the hands of the beneficiary with different rules for spouse or non-spouse beneficiaries.
  • Spouse beneficiaries may be able to roll over the inherited IRA to their own IRA and can defer taking the minimum distributions until age 73 and may be able to transfer the retirement account to an RRSP as described above.
  • Non-spouse beneficiaries have less options than spousal beneficiaries. They have to withdraw the full amount from the U.S. retirement account within 10 years of inheriting it (for U.S. retirement accounts inherited after 2019).

If you have inherited a U.S. retirement plan and live in Canada, U.S. financial advisors may not be able to provide services to you because you are not a U.S. resident. We recommend that you consult a legal and tax professional if you inherit a U.S. retirement plan.

Next Steps

If you’re a Canadian with a U.S. retirement plan, seek advice from a qualified tax and legal professional before acting on any of the information in this article, and a financial advisor to help build, maintain, and protect your wealth throughout life. Together with our Client Consultation Group, a team of highly specialized and accredited professionals that serve clients with complex financial needs, we can help you by taking a personal approach and tailoring solutions to help you meet your financial goals.