The biggest tax bill upon death for many Canadians arises from the mandatory inclusion of any remaining RRSP or RRIF funds as income on their final tax return.
The tax law states that, absent a qualifying rollover to a surviving spouse or partner (or, in very limited situations, a dependent child), the fair market value of your RRSP or RRIF is included in income in your terminal year. With top personal marginal tax rates exceeding 50 per cent in more than half of Canada, your heirs could see a large chunk of your RRSP or RRIF lost to the taxman prior to receiving their inheritance.
But if you inherit your relative’s foreign pension plan, must that also be included in your income? That issue arose in a tax case decided earlier in May.
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The taxpayer’s father had lived in the United States and died in 2011. Among the various assets he owned upon death was a U.S. individual retirement account (IRA) on which the taxpayer and his siblings were named as beneficiaries.
An IRA is similar to a Canadian RRSP in that contributions are tax deductible, the funds grow tax sheltered while invested inside the account, and after age 70.5, there is an annual “required minimum distribution” in which funds are required to be withdrawn and are taxable as income.
In the recent case, the taxpayer’s inherited portion of his father’s IRA was rolled over to an “inherited IRA” in his own name and, in 2012, the funds were ultimately distributed to him in Canada, net of U.S. withholding tax.
The taxpayer did not report the IRA payment on his 2012 Canadian tax return. The Canada Revenue Agency reassessed him, adding the amount he received to his 2012 income, but also allowing a foreign tax credit for the Canadian dollar equivalent of the amount of U.S. tax withheld.
The taxpayer objected and went to Tax Court arguing that the amount received from his IRA should not be subject to tax because it is an inheritance. Generally, inheritances, whether from a Canadian or foreign estate, can be received tax-free.
The judge acknowledged that while the taxpayer did, indeed, receive the funds “as a result of his father’s death and while generally the receipt of an amount distributed from an estate does not in itself trigger tax, there are two important considerations here.”
The first is the taxpayer received the amount as a distribution from an IRA and not from his father’s estate.
Secondly, there is a specific rule in the Canadian Income Tax Act covering such distributions that states a taxpayer must include in income any pension benefit “payment out of … a foreign retirement arrangement established under the laws of a country.” Our tax regulations state that an IRA is a prescribed plan for the purposes of this rule.
As a result, the judge concluded the IRA payment to the taxpayer “is clearly a ‘payment out of’ a ‘foreign retirement arrangement’ within the meaning of (the Act),” and must be included in the taxpayer’s Canadian income.
“The result of this legislation is to treat the IRA distribution in much the same way as if it were a distribution from an RRSP of his father,” the judge said. “However, because U.S. tax was withheld the (taxpayer) benefited from a foreign tax credit.”
Could the taxpayer have done anything differently? We are often asked whether an IRA can be transferred, tax-free, to a Canadian RRSP. The short answer is yes, but it’s complicated and not always worthwhile.
Let’s consider the example of Rob, who used to work in the U.S. but has moved back to Canada. Rob is not a U.S. person for tax purposes. He has $100,000 (Canadian dollar equivalent) in an IRA and wants to move it to his Canadian RRSP. He has no unused RRSP room.
Under U.S. rules, it would be a withdrawal and subject to a withholding tax of 30 per cent. If Rob was under 59.5 years old, there would also be a 10-per-cent penalty tax for an early IRA distribution.
For Canadian tax purposes, Rob would include the $100,000 in his Canadian tax return as foreign pension income (as illustrated by the mechanics in the case above), but he would get an offsetting deduction for a $100,000 RRSP contribution since there is a special rule that allows you to contribute IRA funds to an RRSP without needing unused RRSP room.
The first issue is that to get the full, offsetting deduction, Rob will need to come up with $30,000 (or $40,000, if he is younger than 59.5) in cash to make the full $100,000 RRSP contribution, given the amount lost to U.S. taxes.
But the bigger issue is whether Rob can use the $30,000 (or $40,000, if under 59.5) in foreign tax credits against other income in the year of transfer. If his income in that year was sufficiently high, there should be no problem and he will be able to successfully move his IRA to his RRSP on a tax-deferred basis.
But if Rob is already retired and has very little income in the year of transfer, the foreign tax credit may be permanently lost since it can’t be carried forward. This means the IRA funds transferred to an RRSP may be subjected to double taxation: once at 30 per cent (or 40 per cent if under 59.5) in the year of transfer and again when the RRSP (or, ultimately, RRIF) funds are withdrawn and taxed on his Canadian return.
Jamie Golombek, CPA, CA, CFP, CLU, TEP is the managing director, Tax & Estate Planning with CIBC Financial Planning & Advice in Toronto. [email protected]