A client recently contacted us about rolling over her tax-deferred US retirement accounts to a Canadian RRSP. With many Canadians deciding to leave the US to return to live permanently in Canada, the question of what to do with a 401K and IRA frequently arises.
We advised our client that she has three options to consider: (1) leave the 401k, and IRA plans in the US, (2) cash out the plans before moving back to Canada, or (3) transfer the plans to an RRSP. The best option depends on your tax rates and income in both countries.
Anyone returning to Canada may want to consider preceding future tax-free deferrals on their US retirement plans when the tax on the withdrawal could be higher than the tax savings realized when the contributions to the plan were made. Accordingly, it may be best to withdraw the plan at US tax rates before residence in Canada.
Leaving Your 401K and IRA Plans in the US:
Generally, once US residents holding a qualified retirement plan(such as a 401k or IRA) become Canadian residents, they may continue to defer US and Canadian tax on the income until withdrawal. Under the Canada-US tax treaty, Canadian residents can continue tax deferral of their IRA, 401K, and Roth IRA plans upon returning to Canada. This deferral, however, is not automatic.
Canadian residents must file an election yearly with CRA to continue realizing tax-deferred status on their plan balances. There would be no real tax implications on the earnings within the plan until you begin to make withdrawals, in which case CRA will tax withdrawals — except for payments that can be reasonably considered to be a return of amounts that were contributed to the plan — at the full Canadian tax rate and the US will apply a 15% withholding tax under the tax above treaty.
Transferring to a RRSP:
Provided you comply with the technical requirements, CRA will allow a tax-free transfer of a 401K or IRA to an RRSP without using any impact on your existing RRSP contribution room. On the US side, however, the IRS will impose a withholding tax of 15% on the transferred amount and an additional 10% early withdrawal penalty if you are under 59.5 years of age.
While a 15% tax rate may seem low, you must remember that these funds will be taxed again at Canadian tax rates when withdrawn from the RRSP. This subjects the funds to double taxation. While CRA allows a taxpayer to claim a foreign tax credit for the US withholding tax and the early distribution penalty because the transfer in Canada is tax-exempt, there is a risk that these foreign tax credits will be wasted and can’t be used to offset the Canadian tax at the time the funds are eventually withdrawn from the RRSP. Hence, it may be better to leave the funds in a tax-deferred US plan as long as possible or until you must take minimum distributions from the plan(at 70.5 years of age).
Contact the professionals at Gedeon Law & CPA if you are contemplating a return to Canada and have questions on the tax issues involving your US retirement accounts.
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