Canadian taxation of U.S. not tax-deductible: Roth IRAs and 401(k) accounts

Many Canadians who used to work in the US have Individual Retirement Accounts (IRAs) and qualified retirement plans, such as 401(k) plans. Some of these plans may enjoy the same tax deferral treatment as they would have in the US, while others may request an election to be treated the same way. In this article our knowledgeable Toronto tax lawyers explore the Canadian tax treatment of a traditional IRA or 401(k) or a Roth IRA or 401(k) plan.

IRA or 401(k) plans

IRAs and 401(k) plans are US retirement plans that are similar to Canadian Registered Retirement Savings Plans (RRSP). Generally speaking, plan owners may acquire an IRA by directly contributing to an IRA or transferring their employer-sponsored qualified plans to an IRA after employment termination. By contrast, a 401(k) plan is typically funded by both the employee and the employer. Growth within an IRA or a 401(k) plan is exempt from US income tax until withdrawals are made.

Contrarily, Roth IRAs and Roth 401(k) plans are US deferred savings accounts which resemble the Tax-Free Savings Accounts (TFSA) in Canada. Unlike a traditional IRA or 401(k) plan that is funded with pre-tax money, these plans are funded with after-tax money as contributions to a Roth IRA or Roth 401(k) are not tax deductible. Growth within Roth IRAs and Roth 401(k) plans is also not taxable in the US.

Roth IRA or Roth 401(k) plans are not foreign retirement arrangements.

Under s.56(1)(a)(i)(c.1) of the Income Tax Act, foreign retirement arrangements are exempt from tax to the extent that the amount would not, if the taxpayer were resident in the country (such as the US), be subject to income taxation in the country. The term “foreign retirement arrangement” is defined in subsection 248(1) and section 6803 of the Income Tax Regulations as a plan or arrangement to which subsection 408(a), (b) or (h) of the Internal Revenue Code applies.

Because only traditional IRAs and 401(k) plans are referred to in these provisions, these plans continue to enjoy the tax-deferral treatment in Canada. By contrast, the accrued income in either a Roth IRA or a Roth 401(k) plan will be taxable in Canada each year.

Fortunately, Canadians who own Roth IRAs and Roth 401(k) plans can still file a one-time election to defer tax on their plan balances under paragraph 7 of the Canada-US tax treaty, which treats a Roth IRA or a Roth 401(k) plan as a tax-deferred pension. Although there is no specific form to make the election, the Canada Revenue Agency (CRA) says the following information should be included:

• individual’s name and address, social insurance number, and social security number;
• name and address of Roth IRA trustee or administrator;
• Roth IRA account number;
• date that the Roth IRA was established;
• date that the individual became resident in Canada;
• balance of the Roth IRA on December 31, 2008 or on the date the individual became resident in Canada, whichever is later;
• amount and date of the first Canadian Contribution made to the Roth IRA, if any; and
• a statement signed by the individual indicating that they elect to defer taxation in Canada under paragraph 7 of Article XVIII of the Canada‑U.S. Treaty with respect to any income accrued in the Roth IRA for all tax years.

If the individual owns more than one Roth IRA, the Election should include this information for each Roth IRA. Once an election is made, there is no requirement to make another election for subsequent years. The Election should be filed on or before the individual’s filing-due date for the tax year in which the individual became a resident in Canada. Individuals who did not file an Election within the specified time should contact the Competent Authority Services Division.

Pro tax tips – a Canadian tax resident shall not contribute to their Roth IRA or Roth 401(k) once an election has been filed

If individual residents in Canada contribute to their Roth IRA or Roth 401(k), part of the Roth IRA will cease to be considered a pension. Then the income accrued in the plan after the Canadian Contribution will cease to benefit from the deferral of taxation afforded by the Election and thus becomes subject to Canadian taxation on a current, annual basis. However, any income accrued in the plan before the first Canadian Contribution will continue to be eligible for tax deferral afforded by the Election.  Since these provisions are complex advice from a top Canadian tax lawyer is generally very helpful.

FAQ:

How is a Roth IRA or Roth 401(k) plan taxed in Canada?

Unlike a traditional IRA or 401(k) plan that qualifies for a foreign retirement plan in Canada, the income accrued in a Roth IRA or Roth 401(k) plan is taxable in Canada. However, an individual may file a one-time election to enjoy the tax deferral treatment in Canada under paragraph 7 of the Canada-US tax treaty to treat the plan as a tax-deferred pension.

What happens if a Canadian tax resident contributes to a Roth IRA or Roth 401(k) after filing the one-time election to defer tax?

The income accrued in the plan after the Canadian Contribution will cease to benefit from the deferral of taxation afforded by the Election and thus becomes subject to Canadian taxation on a current, annual basis.

Disclaimer:

Only general information is provided in this article. Only as of the publishing date is it current. It hasn’t been updated, therefore it might no longer be relevant. It cannot or ought not to be relied upon because it does not offer legal advice. Each tax circumstance is unique to its facts and will be different from the instances described in the articles. You should contact a Canadian tax lawyer if you have specific legal inquiries.