Q: There was a lot of press a while back when an Ontario couple had to fight to get compensation after a financial planner steered them into transferring their U.S.-based retirement savings into a Canadian RRSP. The tax hit was large and put a serious dent in their retirement plan. What are the pitfalls and how do you avoid them when it comes to transferring money from a U.S. registered savings plan (Roth IRA or 401K or other) into Canada? And when might it be better to not transfer it at all?
A: The issue is certainly complicated, and fraught with pitfalls and therefore requires the help of qualified experts familiar with all sides of the issue. Best time to do this is before you invest and of course, before you transfer the funds. The tax treatment in Canada essentially depends on what type of retirement savings accounts were held in the U.S. A regular IRA, Roth IRA and 401K are three different account types and not all are treated the same way when it comes to transferring them to an RRSP in Canada.
Individual Retirement Accounts (IRAs), and 401K or 403B Plans, (as opposed to Roth IRAs, which are discussed below) are classed as “foreign retirement arrangements” by the Canadian Income Tax Regulations and are treated like they are registered pension plans by Canada. That means a tax-free transfer of contributions and earnings from an IRA to an RRSP is indeed possible and further sheltering of the investment income earned in these accounts is possible.
But here’s a catch: any employer contributions in these plans cannot be transferred on a tax free rollover. The only opportunity for tax sheltering is to contribute this portion of the plans to an RRSP, but only up to the taxpayer’s unused RRSP contribution room. It may also be possible to transfer the 401K/403B plan to an IRA and then transfer the IRA to an RRSP. However if there is no unused RRSP contribution room, there is no opportunity here.
Angela Preteau, CPA, who is a partner with Frostiak and Leslie in Winnipeg and author of Canadians and the IRS, points out that any taxes paid in the U.S. can of course be used as a foreign tax credit on the Canadian tax return. Depending on how much other income you have in the year of the rollover—and proper planning is required here—it may still be beneficial to fold a U.S. pension into an RRSP.
It is also important to take into account the U.S. implications of the collapse of the plan in question. If the taxpayer is too young to collapse the plan on a tax-free basis, then there may be penalties on the U.S. side that cannot be recouped. The collapse of the plan may also result in a withholding tax in the U.S. Again, this withholding may be recovered as a foreign tax credit if the taxpayer is paying tax in Canada on other income but some or all of it may not be recovered if the taxpayer does not owe sufficient tax in Canada.
“The maximum tax rate applicable in the Canada-U.S. tax treaty is 15%,” says Angela, “and many view the 10% early withdrawal penalty to be a tax penalty that would be caught in the 15% maximum rate. This means that no matter what age you are, 15% is the maximum rate of tax you will pay on the collapse of a US pension, as long as you are living in Canada when it is collapsed.” Again, speaking to a knowledgeable tax professional is highly recommended to prepare the proper treaty forms when filing the U.S. tax return in which the pension income is reported.
Turning now to the Roth IRA, the plan acts like a Tax-Free Savings Account, but with a time limit. In the U.S., contributions are not taxable and earnings are not taxed so long as they are not withdrawn before the taxpayer is 59 ½ years old (or disabled).
In Canada, this investment is not considered to be a “foreign retirement arrangement.” As a result, in general terms, the rules under the Income Tax Regulations don’t apply to Roth IRAs. However, recent amendments to Canada’s tax treaty with the U.S. respect the tax deferral as long as the contribution to the Roth IRA was made while the investor was living in the U.S.
In addition, a one-time irrevocable election must be filed by April 30 of the year following a move to Canada, to exempt from tax the income earned in the Roth IRA and any subsequent distributions. Otherwise, income reporting depends on whether the Roth IRA is structured as a custodial account, a trust or annuity or endowment.
Note that there is no prescribed form for making this important election; simply send a letter to the CRA with your name and address, Social Insurance Number and Social Security Number, the date you became a resident of Canada and the details of the Roth IRA, including name and address of the trustee or administrator, the Roth IRA number and the date the plan was established, the balance in the fund, any Canadian contributions made to the Roth IRA, if any and a statement saying you are election under Paragraph 7 of Article XVIII of the Convention between Canada and the United States of America with Respect to Taxes on Income and on Capital.
As long as an election is filed and the amounts are not taxable in the U.S., there is no need to roll over contributions or non-taxable earnings to an RRSP. They can be rolled over to any non-registered account. Earnings may be rolled over to an RRSP to the extent that they are taxable in the U.S.
Preteau notes: “If the Roth IRA is not a taxable IRA in the U.S., then early withdrawal penalties will not apply if the plan is collapsed prior to a person reaching age 59 ½; rather the 10% penalty is only applied to taxable income.”
In the absence of making the election, or if a Canadian contribution is made to the Roth IRA, Canadian residents have further reporting requirements, aside from their obligations on the Canadian income tax return: they must file Form T1135 Foreign Income Verification Statement, T1141 Information Return re Transfers or Loans to a Non-Resident Trust and/or form T1134-B, Information Return re Controlled Foreign Affiliates, as the case may be, for as long as they own a Roth IRA.
Again, it cannot be overstated that it is critical to consult an expert in US-Canadian taxes before making any transfer to Canada. For more information do invest in Canadians and the IRS by Angela Preteau, the author/instructor of the Knowledge Bureau certificate course, Cross Border Taxation.
Evelyn Jacks is president of Knowledge Bureau, which offers e-learning at knowledgebureau.com. Evelyn tweets @evelynjacks and blogs at evelynjacks.com