RRSP Question

[william502]

I am looking into the tax treatments of RRSPs for US residents looking to make withdrawals. As I understand it, the cost basis of contributions are tax free in the US (subject to Canadian withholding which can be claimed as a foreign tax credit). Any income earned after becoming a US resident is tax deferred (Form 8891).

However, what if one wants to slowly wind down the value of the RRSP rather than taking a lump sum? Could someone help me with the mechanics as I have laid it out below?

Assume...

Canadian resident in Year 1
Contribution $10,000
Interest Income $500
Unrealized capital Gains $1,000

Canadian resident in Year 2
Contribution $10,000
Interest Income $500
Realized Capital Gains $1,000
Unrealized Capital gains $0

Became a US resident in Year 3

Cost Basis on the day of move (which includes realized gains): $22,000 in equivalent US dollars - is this correct?

Contribution: $0
Interest Income of $500
File 8891 to defer tax on $500

Start wind down in year 4

Cost basis: $22,000
Withdrawal $10,000

CRA takes $2,500 (25%)
The $10,000 is tax free in the US.
What about the $500 earned in Year 3? Is that taxable only after one withdraws above and beyond the $22,000 cost base? How does the step up basis apply here?

Thank you.

[nelsona]

Correct in the cost basis.

Incorrect (or at least not advisable) on the taxable amount.

The non-taxable amount is:
[Cost basis]/[FMV on day you take first ammount] * withdrawal amount.

So, say your FMV was $25K on the day you took out the $10K.

Your non-taxable amount is: 22/25 *10 = $8800. You report 10K on 16b and $1200 on 16b as taxable.

Your new cost basis for future withdrawls in $13200.

You see, you don;t have to track your deferred income once you enter US. your deferred income is the differnce between your cost basis and your FMV.

[william502]

Nelson, that was quick and extremely helpful. Thank you.

How is the cost basis affected in future years given fluctuations in the currency exchange rate? It should change every year right? If the US dollar depreciates, the $13,200 new cost basis in my example might be expressed as $14,000 using the avg. exchange rate in another year? Naturally there would be no fx impact on the proration ratio between the cost basis and FMW because both are translated into USD using the same exchange rate.

By extension, does this also mean the withdrawal amount is also translated into a US dollar equivalent using the average exchange rate in effect for the tax year? So if I withdraw $10,000 CAD and have the funds deposited into a Canadian bank and kept in Canadian dollars, I would simply report the $10,000 amount in USD based on the avg. exchange rate for tax purposes despite the fact I kept the funds in Canadian dollars? Any subsequent conversion into USD after the fact (and at a different exchange rate) should not factor into this.

Thanks again!

[nelsona]

Your cost basis is fixed.

When you moved the $22K is evaluated on that date, and you have your cost: say US$21,345.

Of course after that, your Cdn withdrawls and FMV get translated on that day as well, but your origianl cost basis doesn;t cajnge. your C$10K withdrawl contains, say US$8345 non-taxable, which makes your new cost basis US$13,000

I skipped all the conversion on the previous example, because ALL OF IT IS DONE in curent USD after the cost basis evaluation done when you arrived.

[william502]

Hi Nelson. I really appreciate your help. Sorry to belabor this, but I just wanted to run through the mechanics again to make sure I really understand everything. I used Excel to calculate the numbers so they ended being more precise but I tried to keep everything close to our original numbers. I also have a question about a "negative" cost basis at the end as illustrated in the example.

Day of Arrival
$22,000 Cost Basis in $CAD
0.970227273 USD/CAD exchange Rate
$21,345 Cost Basis in US

During Year 1 as US Resident
$3,092 Increase in CAD value (Interest, Realized & Unrealized Cap Gains)
$0.970227273 USD/CAD exchange rate set on arrival date
$3,000 Increase in USD value

End of Year 1
$24,345 FMV at end of Year 1 ($21,345+$3,000)

Footnote: Actual CAD value of account is now $25,092

*******

During Year 2 as US resident
$1,031 Increase in CAD value (Interest, Realized & Unrealized Cap Gains)
$0.970227273 USD/CAD exchange rate set on arrival date
$1,000 Increase in USD value

$10,000 CAD Withdrawal to CAD bank account ($7,500 CAD net after $2,500 CAD withheld by CRA)

For IRS reporting purposes:
$10,000 CAD withdrawal
$0.970227273 USD/CAD exchange rate set on arrival date
$9,702.27 US value of withdrawal

End of Year 2 as US Resident
$15,642.97 FMV at End of Year 2 ($24,345+$1,000-$9702.27)
$11,642.73 New Cost Basis ($21,345-$9,702.27)

For IRS reporting purposes
$7,221.19 Non Taxable ($11,642.73/$15,642.97) * $9702.27
$2,481.08 Taxable ($9792.27-$7221.19)

Footnote: Actual $CAD value of account is now $16,123
*****

Now in Year 3, I want to withdraw the remaining $16,123 CAD in my RRSP assuming no more changes in value.

$16,123 $CAD Withdrawal
$0.9702USD/CAD exchange rate set on arrival date
$15,642.97 US value of withdrawal

$0 FMV at end of Year 3

Cost Basis is now a negative number ($11,643-$15,642.97)
How is this handled and was all of the above correct?

Thanks again!

[nelsona]

I'm not going thru your numbers, but thereare several errors in assumption

Once you establish the cost basis on arrival, in USD, nothing changes this other than withdrawals, and contributions, and these must be determined in USD at the time. Growth does nothing.

Do not focus on the conversion of the growth. Focus on correctly determining the US value of your withdrawals. That is all that matters.

The exchange rate on arrival date is used only once: on arrival date. After that all other conversion are done at the date of the event. FMV is based on the conversion rate.

So once you are in US, a withdrawl of $CXX must be immedaiately convcerted to a USD figure. If it is US$9234 on that day, that is what you use. The NR tax is a quarter of that,. and the US taxable portion is detetrmined as I explained above.

[kvom]

This thread is informative, so rather than starting a new thread I thought I'd ask clarification on my own, similar situation.

I'm a US Citizen who worked in Canada from 1977 to 1981, during which time I contributed to an RRSP. I do not know the account basis, but since the account is at TD I'm sure it can be determined. Some 32 years later the current balance is around $75K, and I am retired in the US.

If I need to convert the basis to $US at the time I moved back (June, 1981), then that will be even lower since the $CDN was about $0.75US.

Assuming I were to withdraw the entire sum, I assume that there is a withholding, and I will have to file a return in both the US and Canada. Can I assume that Canada will tax only the amount above my basis and at the rate for capital gains, whatever that is? I haven't filed Canada taxes for 31 years, so I have no current knowledge of Canada's tax laws or rates.

Can I also assume that in the US the income is also treated as capital gains, or is it regular income? And I would receive a credit for Canadian tax paid?

I don't necessarily need to the money, but it's not earning much at TD, and I'd rather repatriate the funds if that's not too costly.

Thanks for any advice.

[nelsona]

US citizens do not determine basis when returning to US, their basis is determined by their contributions. So, for the 3 years you were contributing, your basis was established as the USD value of those contributions.

Let's say it was US$10K.

In Canada, RRSP funds are taxed at 25% flat. RRIF accounts (which is what you convert RRSPs in order to sytemeatical;ly withdraw from them) are taxed at 15%.

So, lets ay you want to take it all (btw, you must have been reporting the RRSP on a form 8891 for the last 6 years to avoid any penalties, so you would want to take care of this beforehand).

You will withdraw the $75K, (call it US$76K), you will pay US$19K in taxes off the top.

When you report it in US (thru the 8891 form) you will report the US$76K as gross, and the $66K as net (that your gross minus your cost basis of $10K) and pay tax on this.

You will file a form 1116 on which you report the $66K as foreign general income, and the $19K you paid in Cdn taxes, and it will figure credit for you.

[NickH]

kvom, have you considered rolling over your TD RRSP into other Canadian funds, TD or otherwise? From a Canadian perspective, that transaction would be tax-free using form T2033. From a US perspective, if you have elected to defer tax on Form 8891 I believe that transaction would not substantially change tax owing.

Here's an article from August 2010 containing Gordon Pape's best and worst of mutual funds issued by the big five Canadian banks: http://opinion.financialpost.com/2010/0 ... ual-funds/

To properly calculate the cost basis of your RRSP, you need a spreadsheet to record the contributions and exchange rates on either each day or an average rate for the year.

[william502]

Hi Nelson,
Thanks as always for your helpful response.

Putting aside the mechanics of the tax reporting aside for now (I'll get to this later) and assuming one does not wait until retirement age to begin making withdrawals, it seems extremely advantageous to withdraw your RRSP in the US than in Canada.

Yes, the 25% non resident withholding rate is likely more favorable than the marginal rate one would pay in Canada, but I am thinking about this a little bit differently.

If a Canadian resident contributes $10K and they are at a 27% rate, they are essentially deferring $2,700 in income tax for the current tax year. Assume it stays as cash and so the cost basis is $10K when moving to the US. Based on your earlier reply, any withdrawal is taxed on a prorated basis (cost basis/FMV) * withdrawal amount. Assume FMV barely changes following the move given cash is earning 0.5%-1%. As such, the cost basis is practically 99% of the FMV value. In your earlier post, you said the difference is reported as taxable income (16b on the 1040) in the US. In other words, you are essentially withdrawing your $10K of Canadian earned income at a fraction of the rate one would have paid (27% in my example) if you didn't contribute.

Obviously the 25% Canadian withholding still factors in but if you get to deduct this through Schedule A where its a dollar for dollar deduction or Form 1116, you'll get a lot of it back and thus lowering your "effective withdrawal rate" substantially.

Is this the right way to think about this?

Thanks

[nelsona]

A dollar for dollar deduction is obviously noy as good as a dollar for dollar credit.

RRSPs put in at a 27% Cdn tax rate is hardly worth it. Most working Cdns have a much higher marginal rate, which is where it really benefts.

And on withdrawal, it would be FAR better to have made a ton of money in your RRSP after departure, and then withdraw it at a 15% periodic rate (RRIF) and match up the US tax with a credit, not a deduction.

If you are going to leave it in cash in RRSP, then you should just collapse it the day after you become US resident and be done with it.

Then invest it tax free in your US home or Roth.

[kvom]

The mention of form 8891 was a bit alarming as that didn't ring a bell. I pulled up my TurboTax return to look it up, and lo that form has been filed for many years as it is propagated from one year to the next by the software. The form shows my election to defer undistributed earnings on line 6a.

At the present time I don't really need a tax credit since most of my current income is either tax-exempt mutual fund dividends or capital gains for which I have a large capital-loss carryover. So it seems that my options are:

1) For lump-sum withdrawal, wait until mu US tax rate would be around 25% as well

2) Convert to a RRIF and withdraw periodically, probably at the same time I need to start IRA withdrawals (in 7 years). In this case, it may be better to look at an investment with a better return.

[william502]

Hi Nelson,
Sorry if I was not as clear as I was in a bit of rush yesterday evening. I wholeheartedly agree with you – the RRSP should be not be used to simply park cash. I only brought up cash balances earning next to 0% to keep things very simple in order to illustrate what I believe to be a fairly sizable amount of tax savings which compounds over time. I also failed to use the proper tax terminology – credits provide a dollar of dollar reduction in tax owed, while deductions lower taxable income.

If an individual contributes $10K to their RRSP, they are essentially deferring a tax liability of say $3,200 (based on a 32% combined provincial and Federal marginal tax rate for a “high incomeâ€￾ earner). If this same individual decides to withdraw this amount prior to retirement, they would ordinarily pay that marginal rate to the CRA when everything is sorted out at tax time assuming all else is equal (ie. no change in taxable income)

Now compare this to the case when one moves to the US. For the sake of simplicity, let’s assume an individual has kept all contributions in cash and thus preserved the value of all his/her contributions over time. The accumulated cash balance would equal the FMV for IRS tax purposes on the day of arrival. Given that the IRS treats all past contributions as non-taxable capital and only taxes the difference between the cost basis and FMV, I would argue that the US tax rate to do withdraw the money is substantially zero.

This implies that the marginal tax rate to "gain full access" to that cash is essentially zero for the IRS (assume that the interest rate on cash balances is zero so no further interest is ever earned) vs. the 32% tax hit one would take in Canada for pulling out the same amount of money prior to retirement. The magnitude of tax savings will naturally compound itself year after year given multiple contributions -- all made before moving to the US.

Yes, the CRA will withhold their 25%, but the US taxpayer gets this back through Form 1116.

Am I making any sense? Thanks.

[nelsona]

If there is no tax payable in US, the 25% is lost.

Besides, if there is taxable income, it is taxed at the US marginal rate and credited at the effective rate, which is much less.

So, an RRSP withdrawal at 25% tax in canada, will be taxed more in US, and only partially credited, and the state incoem tax adds to it.

So, rather than try to make no income while in US, just take the money as soon as you cross the border, and invest it, either taxable or not, in US.

OR, have it grow, and then have it taxed 15% in canada, and at ta time when you are not earning income in US, and pay roughtly the same tax in US, and the full tax credited.


Its not like we haven;t ran through all these scenarios that you re now discovering.

[william502]

Thanks as always.

>If there is no tax payable in US, the 25% is lost.

Good point.

>Besides, if there is taxable income, it is taxed at the US marginal rate and credited at the effective rate, which is much less.

True but if, at the time of arrival, the entire value of the RRSP is entirely in cash and therefore equal to the cost basis, then there is no Fed taxable income to speak of. The next thing to do would be close the RRSP by withdrawing the entire balance and paying no Fed tax to tap into the accumulated value of one's contributions (assuming no prior loss in value in the RRSP as a Canadian resident). As for state tax, there may be is some tax liability there but I'll leave that out of the picture.

>So, rather than try to make no income while in US, just take the money as soon as you cross the border, and invest it, either taxable or not, in US.

Agreed. As you pointed out, I was just merely running through the various scenarios and asking the resident tax expert to see if I was making sense or not. :) If I am indeed correct, then I see it as a meaningful tax savings for an individual still of working age vs. the same individual in Canada who wants to take money out of their RRSP but ends up getting hit with tax at whatever their marginal rate is.