ROTH IRA TAXATION FOR EXPATS IN CANADA
The importance of income tax treaties should not be underestimated when considering the U.S. tax implications of living abroad. U.S. and foreign tax laws often fall short of ensuring that U.S. expats are on equal tax footing with their non-expat counterparts. In such case, a relevant tax treaty may be available to pick up the slack.
This is particularly true in the case of retirement or other savings accounts that are maintained in cross-border circumstances. The US-Canada tax treaty provides a great example of the benefits a treaty can provide in such a scenario. Unique to the US-Canada tax treaty is a provision that ensures that the U.S. tax exemption on interest accruals and distributions from a Roth IRA are preserved even after a U.S. person has moved to Canada.
As with all tax treaties, this exemption preservation rule comes with its own particular requirements. This underscores the importance of understanding that there is no uniform U.S. tax treaty law – each treaty has its own particular nuances that must be mastered in order to fully realize the benefits of the relevant treaty.
BASICS OF THE ROTH IRA
In general, there are two types of IRAs – the traditional IRA and the Roth IRA. In the case of a traditional IRA, you are allowed a deduction for the amount you contribute to the account, you don’t pay tax on account earnings, but distributions from the account are subject to U.S. income tax. In contrast, in the case of a Roth IRA, you are not allowed a deduction for the amount you contribute to the account, you also don’t pay tax on account earnings, and distributions from the account are not subject to U.S. income tax.
In order to fully participate in a Roth IRA, your income must be under specific threshold amounts set out by the IRS (depending on marital status), which are modified annually. The maximum amount you can contribute to a Roth IRA in 2017 is $5,500. People aged 50 and over can contribute an additional $1,000. Importantly for U.S. expats, you cannot contribute amounts excluded under the foreign earned income exclusion. Tax strategies, such a utilizing foreign tax credits, are available to mitigate the effects of this limitation.
US-CANADA TAX TREATY
Under paragraph 1 of Article XVIII of the US-Canada Tax Treaty, distributions from a “pension” to a resident of Canada generally continue to be exempt from Canadian tax to the extent they would have been exempt from U.S. tax if paid to a resident of the United States. The article provides that the term “pensions” generally includes a Roth IRA.
In addition, under the treaty, residents of Canada generally may make an election under to defer any taxation in Canada with respect to income accrued in a Roth IRA but not distributed by the Roth IRA, until such time as and to the extent that a distribution is made from the Roth IRA. Because distributions will be exempt from Canadian tax to the extent they would have been exempt from U.S. tax if paid to a resident of the United States, the effect of these rules is that, in most cases, no portion of the Roth IRA will be subject to taxation in Canada. Importantly, the election must be made by April 30 with the Canadian Tax Authorities after the year the person becomes a resident of Canada.
Great news so far – however (and yes it does seem like there always is a “however”), an important limitation applies under the treaty as well.
The treaty provides that if an individual who is a resident of Canada makes contributions to a Roth IRA while a resident of Canada, the Roth IRA will cease to be considered a “pension” for treaty purposes at that time with respect to contributions and earnings from such time, and earnings from such time will be subject to tax in Canada in the year of accrual. As such, the Roth IRA will in effect be split into a “frozen” pension that continues to benefit from the exemptions on distributions and accruals and a savings account that does not benefit from the exemptions.
TAX TREATY EXAMPLE
The U.S. Treasury Department, in its Technical Explanation to the Treaty, provides the following helpful example in explaining the rules relevant to the Roth IRA:
Assume, for example, that Mr. X moves to Canada on July 1, 2008. Mr. X has a Roth IRA with a balance of 1,100 on July 1, 2008. Mr. X elects under paragraph 7 of Article XVIII to defer any taxation in Canada with respect to income accrued in his Roth IRA while he is a resident of Canada. Mr. X makes no additional contributions to his Roth IRA until July 1, 2010, when he makes an after-tax contribution of 100. There are accretions of 20 during the period July 1, 2008 through June 30, 2010, which are not taxed in Canada by reason of the election under paragraph 7 of Article XVIII. There are additional accretions of 50 during the period July 1, 2010 through June 30, 2015, which are subject to tax in Canada in the year of accrual. On July 1, 2015, while Mr. X is still a resident of Canada, Mr. X receives a lump-sum distribution of 1,270 from his Roth IRA.
The 1,120 that was in the Roth IRA on June 30, 2010 is treated as a distribution from a pension plan that, pursuant to paragraph 1 of Article XVIII, is exempt from tax in Canada provided it would be exempt from tax in the United States under the Internal Revenue Code if paid to a resident of the United States. The remaining 150 comprises the after-tax contribution of 100 in 2010 and accretions of 50 that were subject to Canadian tax in the year of accrual.
So, for U.S. citizens moving to Canada who want to maintain a Roth IRA account, heed this advice – FIRST, be sure to file the above-described election to defer taxation by April 30 in the year following your move to Canada, and SECOND, think twice before contributing to your Roth IRA while you are a resident of Canada, because the treaty will hot help you avoid taxation on accruals and distributions moving forward.
TAX TREATY EXPERTISE
Because U.S. citizens are subject to the U.S. tax rules even when living and working abroad, tricky cross-border tax issues can arise with respect to even the most basic aspects of normal living. Understanding both the U.S. tax laws and the provisions of a relevant income tax treaty are crucial for minimizing the adverse tax implications associated with cross-border scenarios.
At Expat Tax Professionals, our experts have extensive experience in utilizing all of the tax benefits available to U.S. expats, including treaty benefits when available. We have helped many expats significantly reduce or eliminate their U.S. tax obligations using one or more of these benefits. We are ready to help you with your U.S. tax filings. Please Contact us today!