Residents of Canada: What are the Canadian and U.S. Tax Ramifications of being forced to liquidate a U.S. retirement account.
As mentioned in a previous article, many banks and brokerage firms are informing U.S. non-resident clients that they are no longer able to service their accounts and that their accounts have been restricted or even closed. In that same article, we outlined the following:
- S. citizens and Green Card holders who reside in Canada or anywhere else abroad would be considered to be non-residents for the purposes of these regulations.
- These regulations are not new, but were not generally monitored or enforced.
- Financial institutions have started to enforce these regulations much more diligently.
The options available to an individual for their taxable brokerage accounts once they have received notification that they are required to find another service provider were addressed in the above mentioned article. Individuals with tax-deferred accounts, such as an IRA or 401K, are being told much the same thing. The account holder will generally be told that if they are not able to transfer the account to another service provider within a set period of time, the assets within the account will be liquidated and a distribution will be sent. If a distribution from an IRA/SEP IRA/Roth IRA is received, you have 60 days to deposit the funds into another retirement account with a U.S. custodian or the distribution will become fully taxable. Distributions from an inherited IRA/Roth/SEP IRA do not have a 60 day window.
For many, it is difficult to find an alternate service provider that allows a non-resident to maintain a retirement account in the U.S. Even if a new service provider can be found, it is possible that the new provider will restrict activity within the account, effectively freezing the account. Because of these complications, Canadian residents may feel compelled to liquidate their U.S. retirement accounts.
For the majority of U.S. retirement accounts, a liquidation would have U.S. and Canadian tax implications for both U.S. citizens residing in Canada and Canadian citizens living in Canada. A couple of common scenarios include the following:
- A U.S. citizen owning a U.S. retirement account moved to Canada and became a tax resident of Canada.
- A Canadian citizen who lived in the U.S. for a period of time on a work permit, and who contributed to a U.S. retirement account while living in the U.S., moved back to Canada and once again became a Canadian tax resident.
We will discuss each scenario separately, since the tax implications of the liquidation of the retirement account will be different for each scenario.
U.S. Citizen Becomes a Tax Resident of Canada
As mentioned in our previous article, when you establish income tax residency in Canada, for Canadian income tax purposes, you are deemed to have disposed of all of your property immediately beforehand, with some exceptions, for proceeds equal to the fair market value of that property at that time. You are then deemed to have acquired such property at a cost equal to such fair market value. U.S. retirement accounts are one of the exceptions to this rule. As such, the retirement assets would retain their historical cost basis for both U.S. and Canadian tax purposes.
As a U.S. tax resident, a distribution from most types of U.S. retirement accounts would be taxed as ordinary income subject to taxation at marginal tax rates. Distributions from Roth IRAs are not taxable. The maximum marginal tax rate is currently 37% (2018). Depending upon circumstances such as the age of the recipient, there could potentially be early withdrawal penalties as well.
Canada will also tax the entire distribution from most U.S. retirement accounts. The entire distribution is taxable even though an individual in this scenario did not previously receive a deduction on a Canadian tax return related to the contributions. Distributions from Roth IRAs are not taxable in Canada. The marginal tax rate would depend upon the province of residency. For example, a resident of Ontario would currently have a maximum rate of 53.53% (2018). A foreign tax credit can be claimed in Canada in relation to the U.S. tax payable on the distribution. Early withdrawal penalties are not eligible for a foreign tax credit.
Individuals in this scenario are generally subject to an overall tax rate upon liquidation equal to the Canadian tax rate. The tax payable to the U.S., which is subsequently claimed as a foreign tax credit in Canada, is usually not sufficient to completely eliminate the Canadian tax liability.
Canadian Citizen Resumes Canadian Tax Residency
The second scenario is of a Canadian citizen previously living in the U.S. who moves back to Canada and resumes Canadian tax residency.
In this scenario, the U.S. requires a 30% non-resident withholding tax. Due to the tax treaty between the U.S. and Canada, that rate can be dropped to 15% for periodic payments, but there is some debate about whether or not that applies to a liquidation event, and recently, service providers have been less inclinded to agree to the lower rate. Because of this, we advise our clients to expect a 30% withholding rate from most providers. In order to recuperate the other 15%, the filing of a U.S. non-resident income tax return would be required. Note that recuperating the other 15% would not be required if the entire 30% withholding tax is claimed as a foreign tax credit on the Canadian tax return. In the case of an early withdrawal, the penalty normally imposed would be included in the 15% or 30% tax, which is considered a final tax for U.S. tax purposes.
Canada will also tax the entire distribution from taxable U.S. retirement accounts in the same manner as was discussed in the earlier scenario. A foreign tax credit can be claimed in Canada in relation to the U.S. withholding tax.
Individuals in this scenario are also generally subject to an overall tax rate upon liquidation equal to the Canadian tax rate. The U.S. foreign tax credit is generally not sufficient to completely eliminate the Canadian tax liability.
A relatively common tax planning technique for individuals in this scenario is to roll funds from their IRA into a RRSP in an effort to defer taxation of the IRA income. This strategy is now less attractive due to the application of the higher 30% U.S. non-resident withholding tax. We would also point out that this strategy is generally recommended by service providers that do not have the ability to actively manage U.S. retirement accounts. A more effective solution would be to find a service provider, such as Cardinal Point, that can actively manage the IRA and eliminate the need for a liquidation altogether.
The Cardinal Point Advantage
These examples highlight the complicated and negative tax implications involved with an unexpected liquidation of U.S. retirement accounts. The main negative tax implication being that the full value of most retirement accounts becomes taxable upon liquidation. We recommend that you avoid these unnecessary tax consequences by finding a custodian who is able to manage U.S. retirement accounts for non-residents of the U.S. Cardinal Point has the unique registrations and ability to manage investment portfolios that include accounts in Canada and the United States. As such, we have the ability to actively manage U.S. retirement accounts for our Canadian resident clients.
Cardinal Point has the cross-border financial planning, investment management, and tax expertise to ensure that our clients are able to maintain retirement assets in their country of origin, and to transition other assets from one country to another in a tax-efficient manner. Our clients receive tax planning as a part of their overall financial plan.