US and Canadian tax considerations for withdrawals and transfers to RRSP

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1 Reference Paper for Vancity US and Canadian tax considerations for withdrawals and transfers to RRSP Introduction This paper will discuss the tax implications for Canadian resident who has participated in a US retirement plan, and will be receiving benefits from the plan in the future. This case usually arises when an individual moves to Canada, either as a returning Canadian (after working in the US) or a new immigrant to Canada. The individual usually asks what his options are with regard to the plans. In most cases, the obvious options are to leave the funds in the US and withdraw them upon retirement; or transfer all or a portion of the funds to a Canadian RRSP. The tax implications under either option will vary depending on whether or not the individual is a US citizen / green card holder (a US person ). When reviewing whether to transfer US retirement plans to an RRSP, we assume the individual is not a US person. This is because in most cases, it will not make sense for a US person to make the transfer. The US taxes its citizens on their worldwide income, whether or not they are physically in the United States. Green card holders are treated the same as US citizens for tax purposes. This means that US persons living in Canada must file returns under both systems, and often must pay tax to both governments. Safeguards such as foreign tax credits, the foreign earned income exclusion and the Canada-US tax treaty exist to prevent double taxation. However, because collapsing a US IRA is a taxable event and the US person pays tax on this amount at their marginal tax rate rather than a withholding tax rate, there is no real benefit to the US person in paying tax to collapse a tax-deferred plan, only to contribute the funds back to a Canadian tax-deferred plan and then pay Canadian tax on the future withdrawals. 1

2 Before reviewing the tax implications of transferring the funds, we will review the various types of US retirement plans that the individual may hold on their move to Canada. Descriptions of US Retirement plan vehicles Plans that are Qualified Plans receive special treatment under the Internal Revenue Code ( IRC ). Plans are qualified if they meet certain conditions as outlined in various sections of the IRC. All the plans described below are qualified plans. A summary and comparison of the most common plans (Traditional IRA, Roth IRA and 401(k)) is included in Appendix A. Traditional IRA There are various types of Individual Retirement Arrangements ( IRA ), including SEP IRAs, SIMPLE IRAs and Roth IRAs. An IRA that is not one of these other plans is referred to as a traditional IRA. The IRA is similar to a Canadian RRSP in that limited contributions may be made to the plan annually, and taxation on income earned in the plan is deferred until a withdrawal is made. Contributions Individuals are eligible to contribute to a traditional IRA if they receive taxable compensation during the year, and were not age 70½ by the end of the year. Compensation is generally employment income, and includes wages, salary, bonuses, self-employment income, and commission income. Compensation does not include income from passive investments, rental properties, pensions or annuities, deferred compensation, partnership investments or excluded income. 2

3 Contribution limits to traditional IRAs are quite low. For 2006, the limit is the smaller of: 1. $4,000 (or $5,000 if age 50 or older) and 2. Taxable compensation for the year. The ability to claim a deduction for an IRA contribution depends on several factors: whether the individual is covered by an employer retirement plan; the individual s US filing status (single, married filing jointly, married filing separately; head of household); and the amount of modified adjusted gross income. Most US persons are covered by employer retirement plans (usually a 401(k) plan) or have income that is too high to make deductible contributions. Depending on filing status, the ability to deduct an IRA contribution ends after modified adjusted gross income exceeds $60,000 - $160,000. Individuals may make non-deductible contributions to an IRA within the above limits. Large IRA balances are usually the result of a rollover from 401(k) funds (discussed later on) rather than from the individual making annual contributions. Withdrawals Withdrawals may be made at any time, but on withdrawal, the funds will be taxable, and may be penalized. The withdrawal will be taxable at ordinary income tax rates. Withdrawals made before age 59½ are subject to an additional 10% tax (subject to certain exceptions). 1 Withdrawals made between age 59½ and 70½ are not subject to the 10% additional tax. 1 Withdrawals are permitted before age 59 ½ without incurring the 10% penalty tax in the following situations: funds are used for medical expenses or payment of medical insurance; disability; payments are made to the beneficiary of a deceased IRA owner, distributions are received as an annuity; funds are used for higher education expenses, funds used to buy or build a first home; or distribution is a result of an IRS levy. 3

4 Mandatory distributions must begin by April 1 of the year following the year the IRA owner reaches age 70½. Failure to take the required minimum distribution amount ( RMD ) results in a 50% excise tax on the amounts not distributed. The RMD for each year is calculated using IRS tables that incorporate life expectancies. If the individual is married, the life expectancies of both spouses may factor into calculating the RMD. If the individual withdraws more than the RMD in one year, the excess may not be treated as part of the RMD for the following year. Generally, distributions from a traditional IRA are taxable in the year they are received and taxed as ordinary income. If non-deductible contributions were made, then the individual is not taxed on the return of these contributions. Form 8606 is used to calculate the taxable and non-taxable portion of a distribution. Canadian tax implications Canadian residents who are not US persons are generally not permitted to make contributions to IRAs. US persons may continue to make contributions to an IRA, but will not be able to claim a deduction for the contribution on their Canadian tax return. Investment earnings in an IRA will not be taxable to the beneficiary until the amount is withdrawn. When a withdrawal is made from an IRA, the Canadian tax treatment will follow the US tax treatment; i.e. amounts received from an IRA will be taxable in Canada to the extent that the amount would have been taxable if the person had been resident in the US. 2 As noted above, because most IRA distributions are fully taxable to US persons, it is likely the distributions will be fully taxable for Canadian purposes as well. Under the Canada- US income tax treaty, payments from an IRA should be subject to 15% US withholding tax. A foreign tax credit can be claimed for the withholding tax on the Canadian return. 2 Clause 56(1)(a)(i)(C.1) of the Income Tax Act 4

5 Roth IRA A Roth IRA 3 is a retirement plan where the individual does not receive a deduction for contributions, but growth in the plan accumulates tax-free and distributions are not taxable, subject to certain conditions. A Roth IRA offers tax exempt savings as compared to tax deferred savings with a traditional IRA. Contributions The contribution limit to a Roth IRA is the lesser of the maximum allowable annual IRA contribution, and 100% of individual s taxable compensation for the year. Contributions to both a traditional and Roth IRA plan must be within the IRA contribution limits. Annual contributions are limited based on income thresholds and filing status. Generally, if adjusted gross income is less than $95,000 (single filer) or $150,000 (joint filer), a full contribution may be made to a Roth IRA. Partial contributions are permitted in the phase-out range of $95,000 - $110,000 for single filers; and $150,000 - $160,000 for joint filers. Contributions may be made regardless of age, and even if the individual is a member of a 401(k) plan. Conversion from Traditional IRA to a Roth IRA Individuals may be able to convert a traditional IRA to a Roth IRA, provided that the individual s income does not exceed US $100,000 and the taxpayer is not filing a married filing separate return. The US $100,000 limitation applies to all filing statuses; therefore, for individuals filing jointly or as head of household, the total AGI must be US $100,000 or less to be able to use the conversion provisions. The individual must recognize income up to the value of the IRA at the time of conversion. 3 The Roth IRA is named after the senator who sponsored the legislation to create the IRA. 5

6 Withdrawals Qualified distributions from a Roth IRA are not subject to tax. A qualified distribution is a withdrawal after the plan has been open for at least five years, and meets one or more of the following conditions: the individual is at least age 59½; the individual is disabled; the distribution is paid to a beneficiary or estate after death; or the distribution is used to pay for qualified first-time homebuyer expenses. Early distributions that are not qualified are subject to an additional 10% tax. The additional tax is levied on the earnings in the plan (and not on the original contribution amounts). A Roth IRA is not subject to the minimum distribution rules. This means that the individual is not required to make withdrawals in the year they turn age 70 ½. Canadian tax implications There are no specific rules in the Income Tax Act dealing with Roth IRAs. Earnings within the plan should be treated as exempt from Canadian tax 4, and distributions out of the plan should also not be taxable. 5 4 Per Article XVIII(7) of the Treaty 5 Distributions should not be taxable for one of the following reasons: 1. The distribution is treated as pension income Article XVIII(1) states that pension income arising in the US will not be taxable in Canada if the pension would have been excluded from the recipient s income in the US. 2. If the Roth IRA is a trust, the payments should be considered as a non-taxable return of trust capital. 3. If the Roth IRA is treated as a bank deposit, a withdrawal of funds would not be taxable. 6

7 401(k) Plan A 401(k) plan is a qualified defined contribution plan that takes its name from the section of the Internal Revenue Code that prescribes the rules under which it operates. It is a retirement plan in which an employer permits an employee to defer part of his compensation by contributing that amount to a 401(k) plan. Contributions are made on a pre-tax basis, which allows the employee to reduce his taxable compensation. Many 401(k) plans include a matching contribution from the employer according to a set formula (e.g. match to 50% of the employee s contribution up to a maximum of 6% of compensation). The maximum contribution limit for 2006 is $15,000, but employers may set their own limits (such as up to 6% of compensation). The employer contributions and earnings in the plan are tax deferred until a withdrawal is made; at that time the amount received is fully taxable. Beginning in 2006, 401(k) plans may allow participants to make contributions to a Roth- 401(k) account. The decision to offer this option is at the employer s discretion. Under this new type of arrangement, contributions to a Roth-401(k) account will be taxed in the year made, but future qualified distributions from the account will not be taxed. Withdrawals Generally, withdrawals are limited to the following events: termination from employment, disability, reaching the age of 59 ½, retirement or death. 7

8 The plan may also allow for withdrawals under hardship circumstances or to purchase a home. Similar to IRAs, a 10% penalty tax applies if early withdrawals are made, subject to certain exceptions. 6 When a US person retires or changes jobs, they have a few options relating to their 401(k) plan. They can receive an automatic distribution of the funds; they can transfer their plan to the new employer s plan, or transfer the funds to an IRA. Cashing out the 401(k) plan will generally result in tax and early withdrawal penalties. Transferring the funds to the new employer s plan is a good option if new plan accepts the transfer. As we will discuss below, a rollover from a 401(k) to an RRSP is more complicated, so for individuals moving to Canada, the last option (transfer to an IRA) is usually the best one. The 401(k) funds can be transferred directly to an IRA rollover account with no taxes or penalties. The rollover is not a taxable transaction for Canadian purposes. Any after-tax contributions in the plan cannot be rolled over, but are not taxable on withdrawal. Canadian tax implications Earnings inside the 401(k) plan are tax deferred for Canadian purposes. Withdrawals generally should be taxable on the Canadian return as ordinary income. Withdrawals by a non-resident alien will also be subject to US withholding taxes. Contributions made to a 401(k) are not deductible for Canadian purposes; further, a Canadian resident is not permitted to contribute to both a 401(k) and an RRSP. If a Canadian resident is a member of a 401(k) plan, his RRSP contribution room should be eliminated by a pension adjustment. Therefore, it is not advisable for Canadian residents to continue participating in a 401(k) plan, as they will not have RRSP room available, and 401(k) contributions will not be deductible. 6 The exceptions from the early withdrawal penalty tax for 401(k) plans are the same as for IRAs. See footnote 1. 8

9 SEP-IRA A Simplified Employee Pension (SEP) is a retirement plan designed for small employers or self-employed persons. A SEP is a simple method for a small employer to establish a retirement plan for employees without the complex administration and expense associated with qualified retirement plans. Under a SEP, the employer makes taxdeductible contributions to an IRA in each employee s name. The contributions made by the employer are not taxable to the employee, but distributions out of the SEP IRA are taxable, similar to traditional IRAs. Early withdrawal penalties can apply, and RMDs are required for distributions after age 70½. The employer contributions are discretionary, and limited by an annual compensation limit. For 2005, the contribution limit is 25% of the employee s contribution (20% for self-employment income), to a maximum contribution of $42,000. Keogh Plan A Keogh plan is the self-employed equivalent of qualified retirement plans set up by larger corporations. The plans can be structured as a defined contribution / profit sharing plan, or as a defined benefit plan; each type of plan has different annual contribution limits. These plans are established under strict IRS standards, and require a higher level of setup documentation, and are more complicated than SEPs. The annual contribution limit for defined contribution / profit sharing plans is 20% of self-employment income, to a maximum of $42,000. Profit sharing plans offer flexibility in the amount of contributions each year; contributions can be high or low each year, as long as they do not exceed the maximums. Defined contribution plans require annual contributions. Defined benefit plans are designed to deliver a targeted annual retirement benefit, which for 2005 is the lesser of: 9

10 100% of the participant s average compensation for his highest three consecutive calendar years; or $170,000. The annual contribution sufficient to achieve this benefit must be calculated actuarially and contributions are required every year. Contributions are deductible from self employment income, and earnings in the plan are not taxed until withdrawal. Withdrawals are required by April 1 following the later of the year the individual reaches age 70 ½ or the year the individual retires. Funds taken out are taxed at regular income tax rates. Both SEP-IRAs and Keogh plans offer higher contribution limits than traditional IRAs. Transferring US Retirement Funds to Canadian RRSP Although there are no specific cross border rollover provisions, Canadian law does allow for a transfer from an IRA plan to an RRSP if certain conditions are met; mainly that the withdrawal from the IRA is a lump sum payment and is in respect of contributions made to the plan by the taxpayer or his spouse. 7 Funds from a 401(k) plan can also be transferred to an RRSP if the pension is attributable to services rendered in a period throughout which the recipient was not a resident of Canada. 8 If the individual made contributions to a 401(k) plan, but may have been a resident of Canada during the contribution period, the individual should first roll the 401(k) to an IRA, and then transfer the IRA funds to the RRSP. The transfer of IRA funds to an RRSP is allowed under the Canadian Income Tax Act, whereas the transfer of a 401(k) plan must meet more specific requirements to come 7 The withdrawal from the IRA will be included in income pursuant to clause 56(1)(a)(i)(C.1), and an offsetting deduction for the RRSP contribution permitted under paragraph 60(j)(ii). 8 Income is included under subparagraph 56(1)(a)(i) where the exception in 6(1)(g)(iii) is met; that is, where the pension payment is attributable to services rendered in a period throughout which the recipient was not resident in Canada. The offsetting deduction is permitted under 60(j)(i). 10

11 under the more general provisions of the Act. It is therefore advisable to transfer the funds first from the 401(k) plan to an IRA, and then make the transfer to the RRSP. As discussed above, there are no US or Canadian tax implications on the transfer from a 401(k) plan to an IRA. However, the withdrawal of funds from the IRA will be subject to the early withdrawal penalty (if the individual is under the age 59 ½) and withholding tax if the individual is a non-resident / non-citizen of the US at the time of withdrawal. A US citizen would be subject to US tax on the full withdrawal, subject to the return of nondeductible contributions. It may be possible to transfer a Roth IRA to an RRSP similar to transferring a 401(k) plan as discussed above. However, most individuals will generally not have significantly large balances in their Roth plans, since the Roth IRA contribution limits are quite low, and individuals do not roll their 401(k) plans to Roth IRAs (which would be a taxable transaction). Additionally, because the contributions to a Roth IRA are non-deductible, the return of contributions would be on a tax-free basis in Canada. Income accumulated in the Roth IRA can also be received tax free if properly structured; therefore it would not make sense to transfer the funds to an RRSP. Considerations for US Citizens vs. Canadian NRA A US citizen who withdraws funds from an IRA will pay both the early withdrawal penalty (if under age 59 ½) and income tax on the taxable portion of the IRA. Because of the fully taxable nature of an early IRA withdrawal, it is generally not advisable for US citizens to transfer their funds to an RRSP. However, some individuals may wish to complete the transfer in order to hold all their retirement assets in Canada. If a non-resident alien withdraws funds from an IRA, he will be subject to the early withdrawal penalty (if under age 59 ½) and withholding tax on the payment of US funds to a Canadian resident. There has been some recent debate about whether the withholding tax rate should be 15% under either the Pensions or Other Income articles of 11

12 the Treaty, or 30% under the Internal Revenue Code s general withholding rate on the basis that the Treaty does not apply. The IRS has issued conflicting rulings regarding the non-resident withholding rate for lump sum distributions from a US qualified plan. Past rulings suggested that the distributions would be taxed under the trust rules of the Other Income article of the treaty and not the Pensions article. 9 The Other Income article of the Canadian treaty limits the withholding rate to 15% of the US source income. Under the Internal Revenue Code the 10% early withdrawal penalty tax is considered an income tax, and is also limited by the Treaty rate; therefore, the entire withholding (including the 10% penalty tax) should be limited to 15%. 10 A more recent document from the IRS, in which they were specifically asked the withholding rate for a Canadian on a lump sum distribution from a US retirement plan, states that the withholding rate should be 30%. 11 They explain that the 15% withholding rate in the Pensions article applies only to periodic payments, and the Other Income article applies only to items of income not dealt with in preceding articles of the Treaty. Since the definition of pension provided in the Pensions article does not distinguish between periodic payments and lump sum payments, the lump sum payment is considered a pension payment and is covered by the Pensions article, even though the payment is not eligible for the 15% rate because it is not periodic. However, this ruling applied to a distribution from a pension plan; comments were made in another ruling 12 that once a lump sum payment from a qualified pension plan is rolled over to an IRA, the plan loses its status as a pension. The ruling further states that the US attaches a condition of retirement to its meaning of the term pension. Since no such condition attaches to receipt of a distribution from an IRA (such distributions being available upon demand), it is their view that the distributions are not pension payments, but other income under that article of the treaty. 9 IRS PLR , , IRS PLR IRS Info IRS PLR

13 Based on the comments from this last ruling, it appears that rolling 401(k) funds to an IRA before withdrawing and transferring to an RRSP should result in a 15% withholding tax rate. If the individual pays proper withholding taxes on the withdrawal of IRA funds, he will not be required to file a US tax return; the withholding taxes will represent his final US tax liability. If the funds are issued with no withholding taken, or insufficient withholding taxes (less than 15%) a 1040NR return should be filed and the outstanding amount of taxes paid with the return. The return is due June 15 th. Additional contribution to RRSP When the withdrawal from the IRA is made by a non-resident alien, the plan holder should withhold 15% as discussed above, and the balance will be transferred in a lump sum to the RRSP. Although the withholding tax may be claimed as a foreign tax credit, only 85% of the withdrawal will be available for transfer to the RRSP. The full withdrawal (including the withholding tax) is included in income, but the individual will may have to top up the RRSP contribution from other sources of income if he wishes to fully offset the income inclusion. If the top up contribution is not made, the individual may pay some additional Canadian tax on the overall transfer. Foreign tax credit for withholding tax The withholding tax paid on the withdrawal from the IRA should be creditable on the Canadian return. There is no requirement to reduce the foreign income received by the RRSP contribution when calculating foreign tax credits. 13 If the individual has income from other sources, it may be possible to effectively claim the US withholding taxes against Canadian tax on other income; the result being no more total tax than would have been paid without the IRA withdrawal. It is important to determine that there is enough 13 CRA document

14 other income to fully claim the foreign tax credit. If there is not enough income, the RRSP contribution amount should be reduced so that all the US withholding tax is creditable and no double tax results when the RRSP is distributed. Other considerations Immigration to Canada When an individual immigrates to Canada, he is deemed to dispose and reacquire most of his assets at fair market value. This deemed acquisition determines the basis that Canadian capital gains will be calculated from on the future disposition of those assets. Retirement plan balances are not subject to the deemed disposition and reacquisition provisions; therefore, the full amount of withdrawals from IRAs is generally taxable as described earlier. An IRA is a right or thing CRA has stated that if the owner of an IRA dies before the plan s maturity and the property in the plan was not previously used to acquire an irrevocable annuity, they would generally conclude that the deceased s estate s interest in the IRA would constitute a right or thing for purposes of the Act. 14 The executor of the estate would have the option to file a separate return to report the IRA value. US estate tax issues If a Canadian keeps his retirement plans in the US, the plans are considered US situs assets for purposes of calculating US estate tax. The estate tax implications would depend on the value of the plans, as well as the individual s other US situs assets. A discussion of estate taxes is beyond the scope of this paper, but generally, non-resident aliens are subject to US estate tax only on US situs assets. An extended estate exemption 14 CRA document

15 is provided to Canadians under the treaty, which effectively eliminates US estate tax if the fair market value of the individual s worldwide estate is less than the exemption available to US persons. For 2006, this exemption is equal to US $2,000,000. Therefore, if a Canadian s worldwide estate is less than US $2,000,000, he will not be subject to estate tax. If his estate is worth more than US $2,000,000, he may be subject to estate tax on the US situs assets in his estate up to a maximum rate of 45% of the value. The beneficiary of an IRA is taxable on the distributions; however, if estate tax was paid on the IRA, the beneficiary may be able to claim a deduction for a pro-rata portion of the estate tax that relates to the withdrawal. Expatriation provisions Generally, US persons who surrender their green card or US citizenship may be subject to the expatriation provisions if their net worth is more than US $2,000,000. Under the expatriation provisions, the individual continues to be subject to US income, estate and gift tax on certain US source income and property for ten years after renouncing citizenship or surrendering the greencard. Distributions from a US retirement plan will be considered US source income, and could be subject to expatriation tax. The expatriation tax is calculated using graduated rates applicable to US citizens; alternative minimum tax may also apply. A special foreign tax credit is provided against the US tax imposed for any foreign income or similar tax paid with respect to the items subject to US tax. The credit can only offset the US tax imposed by reason of the expatriation provisions and cannot be used to reduce any other US tax liability. Generally, the credit for foreign taxes will reduce or eliminate the expatriation tax imposed, and most expatriates who move to high-tax foreign jurisdictions (like Canada) will not pay additional US income taxes despite being subject to the expatriation provisions. However, they will remain subject to continued filing requirements and compliance burdens, and the tax implications of every financial transaction should be considered before completing the transaction. 15

16 Appendix A CANADIAN AND US RETIREMENT PLANS COMPARED Type of Plan Canadian RRSP Traditional IRA Roth IRA 401(k) Who can Individuals of any age contribute with earned income Contribution limits Tax deductibility of contribution Taxation of growth Classification of rollover under Canadian Income Tax Act Transfer of funds to an RRSP Age that plan must be collapsed Individual or spouse age 69 or under at the close of the year, with earned income Generally 18% of prior year's earned income to a yearly dollar limit ($C16,500 for 2005, $C18,000 for 2006) Deductible from gross income Canadian taxation deferred until withdrawn then growth and capital taxed as income 60(j)(i) rollover from one Canadian plan to another In most situations, funds should be transferred directly between RRSPs December of year account holder turns age 69 Individuals under 70 ½ at the close of the year, with earned income Maximum of $US4,000 or 100% of earned income; plus, if age of 50 or over, additional catch-up contributions of $US 500. Depends on adjusted gross income of family and participation in other types of plans. Not generally deductible if income exceeds $60,000 - $160,000. Growth not taxed in the U.S. until withdrawn. If contribution was deductible, will be taxable when withdrawn 60(j)(ii) rollover of a foreign retirement arrangement Within taxation year or within 60 days after the end of the year Minimum required distributions begin by April 1 of the year following the year attained age 70 ½ Maximum of $US4,000 or 100% of earned income; plus, if age of 50 or over, additional catch-up contributions of $US 500. Not deductible Growth not taxed in the U.S. provided funds not withdrawn until attained age 59 ½ and plan has been open for five years. To the extent income is not taxed in the U.S., it should not be taxed in Canada 60(j)(ii) rollover of a foreign retirement arrangement but only to the extent funds are taxable in the U.S. Within taxation year or within 60 days after the end of the year No mandatory age at which plan must be collapsed Individuals who redirect part their compensation to a retirement plan on a pretax basis in the U.S. May be matched by employer Maximum of $US15,000 or 100% of pay Contributions made on pre-tax basis; contributions are not included in taxable income. Growth and contribution amount not taxed in the U.S. until withdrawn Not specifically allowed, but 60(j)(i) permits a rollover of a foreign pension plan Within taxation year or within 60 days after the end of the year Distributions may begin at age 59 ½ or upon termination of employment. Can be rolled to an IRA. Distributions must commence by April 1of the year following the year the individual attained age 70 ½ 16