401k retirement
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This article appears in the November issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.

Anyone who’s moved home after an extended stint abroad knows that packing up your belongings must be done with care.

Canadians should take the same approach with the assets accumulated in U.S. retirement accounts such as individual retirement accounts (IRAs) — essentially the U.S. version of an RRSP — or employer-sponsored retirement plans such as a 401(k).

Thanks to provisions in Section 60(j) of the Income Tax Act (ITA), Canadian residents may transfer assets held in these accounts into their RRSPs on a tax-efficient basis without using up contribution room as long as certain requirements are met.

Wilmot George, vice-president and team lead for tax, retirement and estate planning with CI Global Asset Management in Toronto, said the transfer process is complex, especially compared with straightforward domestic rollovers.

“You’re dealing with two sets of tax legislation and there are a lot of moving parts, which will differ depending on the circumstances of an individual taxpayer,” George said.

Pitfall 1: Transferring just because you can

While some Canadians may want to use the ITA transfer provisions merely because they exist, George said leaving the accounts in place can be more beneficial because Canadian tax rules allow Canadian residents to benefit from the same tax-deferred treatment of their funds that would have applied in the U.S.

For clients who think they might return to the U.S., no action is likely the best course of action.

“If you’re back in Canada temporarily, or you intend to retire in the U.S., then it maybe makes more sense to leave the assets there and deal with them once you return,” George said.

Terry Ritchie, a private wealth manager with Cardinal Point Capital Management ULC in Calgary, said accountholders should tell their U.S. financial advisors about any relocation plans, as professionals with U.S. credentials cannot make trades or hold funds on behalf of non-residents unless they also are licensed in the other country.

“It can be a challenge to find a U.S. custodian who is willing to provide services once they see a Canadian address on file, but there are cross-border advisors out there who have people qualified to work in both countries,” Ritchie said.

Still, there are plenty of reasons for Canadian residents to transfer their U.S. retirement accounts to Canada.

“If you’re doing some estate planning and you have a Canadian advisor that you are comfortable with, then [you may prefer to] have the assets closer to [you] in Canada. From an administrative point of view, it’s easier to incorporate them into your plans if they are all managed here,” George said.

For wealthier Canadians, moving money to an RRSP can also help reduce exposure to the U.S. estate tax, because all assets held in 401(k)s and IRAs by non-U.S. persons count toward the U.S. estate tax threshold, said Salvatore De Cillis, a financial advisory consultant with RBC Wealth Management in Toronto.

“Generally, U.S. investments in the RRSP would also be treated as U.S. property [for estate tax purposes], but it gives you control to pick all Canadian stocks or to avoid securities that are considered U.S.-situs property,” De Cillis said.

The U.S. estate tax may be payable on U.S. property if a person has a worldwide estate greater than US$12.92 million in 2023. Further, the estate of any person with more than US$60,000 in U.S. property is required to file a return with the U.S. Internal Revenue Service (IRS), which could slow the distribution of assets to beneficiaries.

The same reasoning does not apply to U.S. citizens and green-card holders considered domiciled in the U.S., De Cillis added, because the IRS counts all investments in a U.S. person’s RRSP toward the estate-tax threshold.

Pitfall 2: Pension plan or retirement arrangement?

Canadian residents who are ready to transfer their U.S. retirement accounts to their RRSP have two pathways for doing so without using up contribution room, depending on whether their account qualifies as a foreign pension plan (FPP) or a foreign retirement arrangement (FRA).

The Canada Revenue Agency (CRA) considers a 401(k) an FPP for the purposes of an RRSP transfer as long as the entire amount in the 401(k) is attributable to work done while the person was a non-resident of Canada.

De Cillis said other, less common tax-deferred pension plans, such as the 403(b) or 457(b), which are designed for U.S. teachers and other employees working in the public sector or for non-profits, also may qualify as FPPs.

However, he recommends getting a professional opinion. “Even in the planning stage before [moving] to Canada, I tell clients they have to get their plans reviewed [by an accountant] so they can fully understand what the treatment will be,” he said.

By contrast, IRAs are treated by the CRA as FRAs. An FRA transfer may include contributions made while the owner was resident in Canada, but not amounts contributed by an employer or anyone other than the taxpayer or their spouse.

A long-standing CRA interpretation indicates that amounts rolled over from a 401(k) into an IRA can potentially qualify for an FRA transfer, even if the original plan included contributions made by the employer.

Still, De Cillis said Canadians whose U.S. work overlapped with their Canadian residency should take care when rolling over funds from a 401(k) to an IRA because of another piece of CRA guidance suggesting the agency might apply the general anti-avoidance rule to transactions made purely to defeat the non-residence requirement associated with an FPP transfer.

Pitfall 3: Payable Canadian tax shortage

For both FPP and FRA transfers to an RRSP, accountholders begin the process by collapsing their U.S. plan and declaring the equivalent amount in their Canadian income.

U.S. plan administrators typically apply a 30% withholding tax to lump-sum withdrawals by Canadian residents, and the IRS will impose a 10% penalty to distributions to anyone under 59.5 years old. The withholding tax and penalty usually can be partially or fully recovered when the Canadian resident claims the foreign tax credit (FTC) on their tax return.

However, to make the full RRSP contribution and therefore gain the full available RRSP contribution deduction, the Canadian resident will need to use other funds to top up the withholding tax and penalties while waiting for their tax refund.

The tax neutrality of an RRSP transfer also hinges on the Canadian resident’s ability to use the full FTC in the same tax year as the transfer, as this amount cannot be carried forward.

“There are lots of situations where someone has retired or they’re about to retire and their income is not as high as it used to be, so they don’t have enough tax payable in Canada to recoup the U.S. taxes that were withheld,” said Jacqueline Power, assistant vice-president of tax and estate planning with Mackenzie Investments.

Reducing the withholding tax to 15% may be possible by filing a W8-BEN form with the institution holding the retirement account, but U.S. plan administrators are increasingly unwilling to stray from the standard 30% withholding rate.

De Cillis cautioned against attempting to split a lump-sum withdrawal across more than two tax years. He said the CRA could view this as a violation of the ITA rules, which do not apply to a series of periodic payments.

Instead, to use up the full foreign tax credit, “you could create additional taxable income by realizing gains from your other assets or you could delay claiming certain optional deductions that could wait for another year,” De Cillis added.