We recently had a client contact us about rolling over her tax deferred US retirement accounts to a Canadian RRSP. With many Canadians deciding to leave the US in favor of returning to live permanently in Canada, the question of what to do with a 401K and IRA comes up frequently.
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 foregoing 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 where made. Accordingly, it may be best to withdraw the plan at US tax rates before taking up residence in Canada.
Leaving Your 401K and IRA Plans in the US
In general, 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 taxation 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 need to file an election each year 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 withdrawal, in which case CRA will tax withdrawals — except for payments that can be reasonably considered to be a return of amounts which were contributed to the plan — at the full Canadian tax rate and the US will apply a 15% withholding tax under the aforementioned tax 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 a 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seem low, you need to keep in mind that these same funds will be taxed again at Canadian tax rates when the funds are withdrawn from the RRSP.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 a long possible or until you are required to 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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