Cross-Border Tax Issues: Canadian Residents with U.S. IRAs
by George Gonzalez
A number of tax traps lie in wait for Canadians returning to Canada, and U.S. citizens moving to Canada, who hold a U.S. Individual Retirement Account (IRA). Diligent tax planning requires awareness of these traps before making a move to (or move back to) Canada. If you own an IRA and have already moved to Canada, then awareness may possibly still allow time to take appropriate action.
U.S. Individual Retirement Accounts (IRAs) – Basics
IRAs are a type of qualified investment vehicle. “Qualified” means that they meet certain U.S. tax requirements that result in favorable tax treatment. The word “qualified” in this context is equivalent to the word “registered” in Canada: “registered” means that the retirement plan meets certain Canadian tax requirements that result in favorable tax treatment.
During its life, IRA funds pass through three main phases:
- income accumulation;
The tax effect during each phase differs depending on the type of IRA. There are more than one type, and among them are traditional IRAs, Roth IRAs, non-deductible IRAs, rollover IRAs, SEP IRAs and SIMPLE IRAs. Other types of U.S. qualified retirement vehicles, which are not IRAs, include 401(k) plans, defined contribution plans, and defined benefit plans.
In this article I focus on Roth IRAs and traditional IRAs.
A repatriating Canadian from the U.S., or a U.S. citizen who moves to Canada, is subject to the Canadian taxation rules applicable to their U.S. IRA(s). Under Canadian tax law, as under U.S. tax law, there is a substantial difference between the tax treatment of a traditional IRA versus that of a Roth IRA.
Before discussing the cross-border tax issues related to traditional IRAs and Roth IRAs, let us examine a related aspect of a move from the U.S. to Canada: whether the U.S. financial advisory firm that holds your IRA funds is able and willing to serve as custodian for your IRA after you move to Canada.
Will Your U.S. Financial Advisor Continue Serving as IRA Custodian After Your Move?
U.S. securities regulations require financial advisors to be registered in the jurisdiction where their client resides. Thus, if a U.S. advisor’s client moves to Canada and the advisor is not dually registered in the U.S. and Canada, they cannot continue to serve as the client’s financial advisor. (Similarly, under Canadian regulations, Canadian financial advisors are not allowed to deal with clients in the U.S. unless they are registered in both jurisdictions.)
This frequently presents a problem as many financial advisors are not dually registered in the U.S. and Canada. The U.S. financial advisory firm where the client’s IRA funds are held, upon learning that you are moving or have moved to Canada, may very well advise you to make immediate arrangements to close the IRA. The common time frame they give you is typically 30 to 60 days.
Prior to closing their IRA account, an individual would likely either transfer the funds to another U.S. advisor or simply withdraw the funds. If the individual does not close the IRA within the period given by the financial advisory firm, the firm will liquidate the funds in the account, withhold U.S. taxes, remit the net after-tax amount to the client, and close the account.
This an important point to keep in mind in your IRA cross-border tax planning.
I next discuss the taxation issues presented by Roth IRAs and traditional IRAs in a cross-border move from the U.S. to Canada.
Tax Ramifications of a Move to Canada – Roth IRA
A Roth IRA is a lot like a Canadian Tax-Free Savings Account (TFSA): (1) contributions are not tax-deductible, (2) income accumulates on a tax-free basis, and (3) withdrawals are fully non-taxable.
In terms of U.S. taxation, if you withdraw funds out of your Roth IRA after moving to Canada, there is no U.S. taxation.
In Canada, Roth IRA withdrawals are also not taxable if certain formal requirements are followed. One requirement is that no contributions to the Roth IRA are made after the move to Canada. If one or more contributions to the Roth IRA are made after the move, Canada will no longer consider funds in the Roth IRA as non-taxable. The result will be Canadian taxation of income accumulations in, as well as withdrawals from, the Roth IRA.
Another formal requirement to avoid Canadian taxation of Roth IRA funds is the requirement for the taxpayer to make a timely election under the Canada-U.S. tax treaty to defer taxation of the Roth IRA. With a timely and properly filed election, withdrawals from a Roth IRA by a Canadian resident will be exempt from Canadian tax, as they are from U.S. tax.
The election must be made no later than the filing deadline for Canadian individual income tax returns for the year that the individual moves to Canada (normally April 30 although in 2023 it is May 1). For example, if you moved to Canada in 2022, the deadline is May 1, 2023. If you were to move to Canada in 2023, the deadline would be April 30, 2024.
The election may be filed by including an election statement with the Canadian individual income tax return, or it may be filed separately with the Canada Revenue Agency (CRA). The CRA provides published guidance on this election in their Income Tax Folio S5-F3-C1, Taxation of a Roth IRA.
If you have a Roth IRA and are moving to Canada, work with your tax advisor to ensure you fulfill the requirements for having your Roth IRA exempt from Canadian taxation.
Tax Ramifications of a Move to Canada – Traditional IRA
A traditional IRA is a lot like a Canadian Registered Retirement Savings Plan (RRSP). The tax treatment of this type of IRA during each of the main phases in the life of the account are: (1) contributions are tax-deductible; (2) income accumulates on a tax-free basis; and (3) withdrawals are fully taxable.
For the owner of a traditional IRA who moves to Canada from the U.S., the best tax planning approach, if it is feasible, is usually to leave the traditional IRA in place, i.e., with the U.S. financial advisor. After retirement, as funds are withdrawn, there will be both Canadian and U.S taxation on the withdrawals. A foreign tax credit for U.S. taxes paid is also available for the Canadian tax return, serving to mitigate the overall taxes paid on IRA withdrawals.
This tax planning strategy may be easier said than done, however, because of the possibility that the financial advisory firm where the IRA funds are held will not allow non-U.S. residents to keep their IRA with them. This was discussed in the first section above, “Will the U.S. Financial Advisor Continue Serving as IRA Custodian After Your Move?”.
Funds withdrawn from a traditional IRA are subject to a withholding tax and are subject to full U.S. Taxation. The amount of the tax depends on whether the individual is a U.S. citizen and, if the individual is not, whether they reside in the U.S. or not.
If the individual is a U.S. citizen, the withholding percentage will usually be 10%. The 10% amount withheld is later allowed as a credit when the individual files their U.S. tax return and includes the IRA withdrawal as an item of income in their return. The same tax treatment applies for non-U.S. citizens who reside in the U.S. (“resident aliens”).
If the individual is a repatriating Canadian who is not a U.S. citizen, amounts withheld after the move are subject to a withholding tax of 30%, unless the financial advisory firm is notified that the new country of residence is Canada, and that withholding should be in compliance with the Canada-U.S. tax treaty, i.e., at a 15% withholding rate. This withholding tax represents the final U.S. tax obligation, and no U.S. income tax return is required to report the IRA withdrawal.
Tax Planning Points: Keeping Your IRA with a U.S. Financial Advisor
If it is possible to keep the traditional IRA with a U.S. financial advisor, under the Canada-U.S. tax treaty the taxpayer may enjoy continued favorable tax treatment on the IRA after moving to Canada, both on the U.S. side and the Canadian side.
However, for Canadian tax purposes, tax deferral on traditional IRAs, while income accumulates and prior to withdrawals, does not happen automatically. You are required to file an election each year with your Canadian tax return to defer Canadian tax on your IRA balances. Unlike with Roth IRAs, the CRA has not published any guidance on how to make this election for traditional IRAs. Presumably the election would have to be made by including a statement with the annual Canadian income tax return that refers to Article XVIII, Paragraph 1 of the Canada-U.S. treaty. Check with your tax advisor on this.
If it is not possible to keep the traditional IRA with a U.S. financial advisor, then there are essentially three other choices that can be made to deal with the situation:
- Transfer the U.S. traditional IRA to a Canadian RRSP.
- Withdraw the traditional IRA money as a lump sum.
- Convert a traditional IRA to a Roth IRA.
Tax Planning Points: Transferring Your IRA Funds to a Canadian RRSP
There are two parts to the tax effect of a transfer of funds from a U.S. IRA to a Canadian RRSP. On the U.S. side, if the individual is a U.S. citizen, the transfer will be considered a withdrawal and the amount transferred will be includable as taxable income in the U.S. tax return for the year of withdrawal, and U.S. tax will be paid according to U.S. individual tax rates.
Since this transfer for U.S. tax purposes is considered a withdrawal, there will be a 10% withholding tax paid on the transfer, like the 10% withholding previously mentioned. The amount withheld will be included as a withholding tax credit in the U.S. tax return.
If the individual is not a U.S. citizen, and has moved back to Canada, they will pay tax on the basis of being a non-resident alien (i.e., a non-U.S. citizen who resides outside of the U.S.). There will be a withholding tax of 30%, or a reduced tax of 15% under the Canada-U.S. tax treaty if properly handled by the financial advisor where the IRA funds are held. This withholding tax represents the final U.S. tax obligation, and no U.S. income tax return is required to report the IRA withdrawal.
On the Canadian side, special provisions apply to the transfer of funds from a traditional IRA to a Canadian RRSP. The Canada-U.S. tax treaty allows for such a transfer without the penalty of double taxation. Mechanically, the new Canadian resident will have the proceeds taxed as Canadian income in the year of the transfer while also being entitled to an RRSP deduction for the same amount. The transfer creates RRSP room for the amount transferred, which is meant to offset the income inclusion, so the net effect on Canadian taxes should be zero or close to zero.
A caveat: it is not possible to transfer funds in the opposite direction, i.e., from a RRSP to an IRA. Therefore, this strategy of transferring amounts in a traditional IRA to a RRSP makes sense primarily for taxpayers who are moving to Canada permanently, or moving back to Canada permanently, as the case may be. If the taxpayer intends to return to the U.S., this may not be a good strategy.
Tax Planning Points: Withdrawing Funds from an IRA
The result of this strategy is dependent, in part, on the timing. If withdrawal happens before the individual moves to Canada, then there is a U.S. tax effect only. The amount of the withdrawal is fully taxable as U.S. taxable income, and tax is paid according to U.S. tax rates (which apply to U.S. citizens as well as resident aliens). There would be no Canadian tax to be paid on the withdrawal.
If the withdrawal happens after the individual moves to Canada, on the U.S. side the effect is as described above under the subsection “Transferring Your IRA Funds to a Canadian RRSP”. Here, if the individual is a U.S. citizen, the withdrawal is considered fully taxable U.S. income, and tax is paid according to U.S. tax rates. If the individual is not a U.S. citizen, the withdrawal will be taxed on the basis of the individual being a non-resident alien, and U.S. tax will be paid through withholding as previously described in the last subsection.
On the Canadian side, the amount of the IRA withdrawal will be taxable as Canadian taxable income. A foreign tax credit will be allowable for U.S. taxes paid on the same IRA withdrawal.
Tax Planning Points: Convert a Traditional IRA to a Roth IRA
This strategy should only be contemplated before a move to Canada, because implementing the strategy after a move will likely have severe negative ramifications on your Canadian tax bill. Implementation of this strategy pre-move will have U.S. tax ramifications only.
Under U.S. tax laws, the conversion of funds from a traditional IRA to a Roth IRA results in full taxation of the amount converted. Subsequently, all funds within the Roth IRA earn income tax-free and future withdrawals (after a minimum of five years) will be fully non-taxable. From a tax standpoint, it is best to convert traditional IRA funds to a Roth IRA in a year(s) when you are in a lower tax bracket than usual. One approach to accomplish this is to convert traditional IRA funds piecemeal over more than one year, so as to benefit from multiple progressive tax rates over multiple years.
U.S. citizens who plan to move to Canada, and Canadian citizens who are planning to return to Canada, who own one or more U.S. IRAs should consider a number of tax planning issues in order to avoid potential tax traps.
One issue relates to the holding of IRA funds by a U.S. financial advisor. Will your U.S. financial advisor be able and willing to continue serving in this capacity after your move? If not, you may want to consider finding a financial advisor who is dually registered in Canada and the U.S. to whom you can transfer, or “rollover”, your IRA funds. Doing so early will allow you greater flexibility later.
If you have a Roth IRA, ensure that you comply with the requirements that result in exemption of Canadian tax on the Roth IRA funds.
If you have a traditional IRA, a number of issues and decision points may come into play that will require diligent tax planning. Some discussed in this article are:
- Should you leave the IRA funds in the U.S. (if allowable) after the move?
- Should you withdraw the IRA funds as a lump sum?
- Should you transfer the funds in the U.S. traditional IRA to a Canadian RRSP after the move?
- Should you convert the traditional IRA to a Roth IRA before moving to Canada?