Many Canadians, who have moved to the U.S., return to Canada with substantial sums to their credit in U.S. 401K plans (the U.S. equivalent of a Canadian RPP).
Often, for one reason or another, they don’t want to leave those funds in the 401K plan after their return to Canada.
What are the Canadian and U.S. income tax implications if they “cash out” after returning?
Assuming the returning expat is not a U.S. citizen or resident alien at the time of cashing-out, the U.S. will levy a 30% withholding tax on the payment (NB-I am advised that the U.S. will allow 15% tax rate provided for pension payments under Article XVIII(2)(a) of the Canada-US Tax Convention (“the Treaty”) even for a lump-sum payment).
In addition, if the recipient is under 59 ½ years of age at the time of withdrawal, the U.S. will also levy an additional tax of 10%.
In Canada, the gross amount of the withdrawal will be taxable under paragraph 56(1)(a) of the Income Tax Act (‘the Act”).
However, Canada will allow a foreign tax credit for U.S. taxes paid (including the 10% penalty if applicable-at one time, the CRA attempted to deny credit for this, but subsequently reversed their position).
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It is possible to avoid Canadian taxation by making an equivalent contribution to a Registered Retirement Savings Plan (“RRSP”) within 60 days after the end of the year in which the 401K payment was received and designating the contribution as a rollover under paragraph 60(j) of the Act.
Now here is the really interesting part: one might think that if the 401K payment is sheltered by an offsetting RRSP deduction, it would not be possible to claim a credit for the U.S. taxes. However, that is not the case! Subject to normal limitations, the credit for U.S. taxes may still be claimed. This is because of the fact that the deduction for the RRSP contribution under paragraph 60(j) is not considered to be a reduction in the amount of U.S. source income for the purposes of computing the foreign tax credit under subsection 126(1) of the Act. Of course, the amount of the credit will depend on the taxpayer’s total income and tax situation for the year, and for substantial amounts it would probably be a good idea to do a “dry run” (i.e. pro-forma tax calculation) before cashing out to determine how much of the U.S. taxes would be recovered. In certain cases, it might make sense to wait until the year after returning to Canada so that there would be a full year’s income on the Canadian return-more room for a foreign tax credit.
Another option to consider, in certain cases, would be to transfer the funds in the 401K to a (conventional) IRA. This transfer would be a tax-free in the U.S., and, because of the wording of Article XVIII(1) of the Treaty, should therefore also be tax-free in Canada.
Subsequent withdrawals from the IRA will be taxable in the U.S. and Canada, with foreign tax credits allowed in Canada.
ABOUT THE AUTHOR OF THIS ARTICLE
Michael I. Atlas, CPA,CA,CPA(ILL),TEP
Michael Atlas is one of the most prominent international tax experts in Canada. He advises accounting and law firms all across Canada, as well as select private clients (corporate and personal) worldwide. He can be reached by phone (416.860.9175) or email (matlas@TaxCA.com).
