I'm helping my 24-year-old son with his return. He is a dual citizen, Canada and U.S., and a permanent resident of Canada.
His RRSP contribution plus the income earned inside the plan does not exceed his standard deduction. I'm thinking it would be good *not* to defer his RRSP in that case. My reasoning is, if he declares the year's contribution plus any earnings every year for as long as he can, he will have no U.S. tax liability on that portion of his final RRSP. Does anyone have any advice on the pro's and con's of this?
If he didn't defer, I figure he would still have to file a Form 8891 in order to comply with the Cda-US tax treaty. But he would check "no" for 6a, leaving b and c blank. Then instead of stopping at line 8, he would include his contributions to the plan during the year on line 9, and under 10, he would enter the appropriate amounts in 10a, b, d and/or e. Is that right?
Incidentally, are DRiPs ordinary dividends?
Also, if he made a single contribution, do we use the exchange rate on that date? Likewise, for the plan balance at the end of the year, do we use the exchange rate at Dec. 31st? Or would we use the average exchange rate for the year for everything? I'd like to know the answer for our records, whatever we do.
Thanks in advance for your thoughts.
RRSPs: pro's and con's of deferral; Form 8891
Moderator: Mark T Serbinski CA CPA
Lets set the groundwork: First, using 8891 while NOT making the election, is to comply with IRS foreign trust rules for RRSP/RRIFs (Form 3520). This has nothing to do with the treaty. Only the actual election to defer is related to the treaty.
Second, with the new Foreign earned income exclusion (FEIE or 2555 method) rules, it is no longer true that taking the FEIE and leaving oneself with less than the standard deduction results in no income tax. If one has unexcluded (or unexcludable) income, there will be some US tax to pay. These rules changed for the 2006 tax year, and are making many US cits living in canada switch from the 2555 method over to the Foreign Tax credit (FTC or 1116-only) method of tax relief on their Cdn wages, since by 1116 it is far more likely (though more complicated) that no US tax will be due in the end.
Third, it is not technically permissible to only 'partially' use the FEIE. So when you say "if he declares the year's contribution", you are in effect saying that he would reduce his exclusion by the ammount of RRSP contributions he made, thus reporting the income. IRS can take the position that not excluding all income that can be excluded as grounds for denying the FEIE for that year, and the next 5.
However, from my understanding of IRS rules on calculating the 'investement in a contract'(the portion that is not taxable upon withdrawal) the fact that the contributions would be excluded using FEIE does NOT prevent these from being viewed as non-deductible contributions (in fact the old Rev.Proc 89-45 on RRSPs does not exclude these in determining 'investment'), so I see no need to segregate one's RRSP contributions from the FEIE to make them later non-taxable. And if you use the 1116 method rather than 2555 then this is not an issue at all.
So, you are left with the yearly generated income, which will be cap gains, dividends, and interest/other income. It is likely that any US tax he would pay on these would be minimal (but there would likely be some tax regardless of the method used). The question becomes, would it be smaller than the differnce he would pay later when he would pay Cdn tax on all the RRSP and US tax on the 'deferred growth'.
My guess is that until and unless his wages and other income (including the RRSP generated income) would put him in the higher tax brackets (like the 28% one when his income is roughly $90,000 as single) he should resist the temptation to use the deferral, and simply declare the income every year. That way his 'investment in the contract' would be the contributions PLUS any declared income.
Remember that once you make the traty election it is irrevocable, so, while contributions would continue to add to the 'investment' the growth from that year forward would now become subject to US tax, eventually, when the RRSP/RRIF is being drawn down or collapsed.
Things that might affect this decision, other than the yearly income he makes would be: moving to the US (which would introduce state tax in the mix), getting married to someone with their own RRSP, having kids, moving to another foreign country, further changes in 2555 or 1116 rules. Hopefully at some point the revenues generated by the RRSP will be so large that the deferral will be a no-brainer. There is also the recently announced discussions that US/canada are underatking to address how pension contributions are handled by both countries. This could result in RRSP contributions becoming fully deductible in US (which would then make them fully taxable in US as well).This could also usher in a Cdn Roth system, which would require review of one's entire pension strategy.
Remember, in the end, there will be Cdn tax to be paid on ALL the RRSP, so it is pointless to be over-aggressive in trying to make the US taxable ammount too small, since this will not reduce the Cdn tax.
Remember too, that whether using the deferral, or paying as you go, there is huge paperwork associated with it, as well as complex calculations and interpretations to make.
You brought up just one: what is a qualified dividend. You would need to ask the company in whose stock your invested to determine if their dividends are quilified by IRS rules (the fact that it is a drip is meaningless), if you don't get a specific answer, I would err on the side of non-qualified. same for any dividend in an RRSP (if not deferring). You would need to determine what portion is qualified (an impossibility for a mutual fund). Even cap gain mutual fund distributions could be considered ordinary income by IRS. You also have the issue of Cdn currency held inside or outside an RRSP accruing 'currency gains/losses' which IRS considers other income, when it is 'sold' to buy investments.
The rule of thumb on exchage rates is: if you do periodic transactions, use an average, iff you do occasional transations, use date specific. If it asks for year-end, use Dec 31st. So in your son's case, if he made monthly contrib, he would determine the US value of the contribs with a yearly average, if he also made a withdrawl, or got a dividend on a specific date, he would value that dividend with date specific rate. When the form asks for year-end value (which is meaningless for any IRS purpose, btw) you should use the Dec 31 rate. Inconsistent? Just be consistently inconsisitent and you will be fine. that is why we have spreadsheets.
So you have 2 decisions to make. Whether or not your son should use FEIE-FTC (even if you use FEIE there is always other income that needs to be handled by 1116) or FTC-only (FTC is the way of the future for all US citizens in canada), and then whether to defer taxation on RRSP or wait.
Second, with the new Foreign earned income exclusion (FEIE or 2555 method) rules, it is no longer true that taking the FEIE and leaving oneself with less than the standard deduction results in no income tax. If one has unexcluded (or unexcludable) income, there will be some US tax to pay. These rules changed for the 2006 tax year, and are making many US cits living in canada switch from the 2555 method over to the Foreign Tax credit (FTC or 1116-only) method of tax relief on their Cdn wages, since by 1116 it is far more likely (though more complicated) that no US tax will be due in the end.
Third, it is not technically permissible to only 'partially' use the FEIE. So when you say "if he declares the year's contribution", you are in effect saying that he would reduce his exclusion by the ammount of RRSP contributions he made, thus reporting the income. IRS can take the position that not excluding all income that can be excluded as grounds for denying the FEIE for that year, and the next 5.
However, from my understanding of IRS rules on calculating the 'investement in a contract'(the portion that is not taxable upon withdrawal) the fact that the contributions would be excluded using FEIE does NOT prevent these from being viewed as non-deductible contributions (in fact the old Rev.Proc 89-45 on RRSPs does not exclude these in determining 'investment'), so I see no need to segregate one's RRSP contributions from the FEIE to make them later non-taxable. And if you use the 1116 method rather than 2555 then this is not an issue at all.
So, you are left with the yearly generated income, which will be cap gains, dividends, and interest/other income. It is likely that any US tax he would pay on these would be minimal (but there would likely be some tax regardless of the method used). The question becomes, would it be smaller than the differnce he would pay later when he would pay Cdn tax on all the RRSP and US tax on the 'deferred growth'.
My guess is that until and unless his wages and other income (including the RRSP generated income) would put him in the higher tax brackets (like the 28% one when his income is roughly $90,000 as single) he should resist the temptation to use the deferral, and simply declare the income every year. That way his 'investment in the contract' would be the contributions PLUS any declared income.
Remember that once you make the traty election it is irrevocable, so, while contributions would continue to add to the 'investment' the growth from that year forward would now become subject to US tax, eventually, when the RRSP/RRIF is being drawn down or collapsed.
Things that might affect this decision, other than the yearly income he makes would be: moving to the US (which would introduce state tax in the mix), getting married to someone with their own RRSP, having kids, moving to another foreign country, further changes in 2555 or 1116 rules. Hopefully at some point the revenues generated by the RRSP will be so large that the deferral will be a no-brainer. There is also the recently announced discussions that US/canada are underatking to address how pension contributions are handled by both countries. This could result in RRSP contributions becoming fully deductible in US (which would then make them fully taxable in US as well).This could also usher in a Cdn Roth system, which would require review of one's entire pension strategy.
Remember, in the end, there will be Cdn tax to be paid on ALL the RRSP, so it is pointless to be over-aggressive in trying to make the US taxable ammount too small, since this will not reduce the Cdn tax.
Remember too, that whether using the deferral, or paying as you go, there is huge paperwork associated with it, as well as complex calculations and interpretations to make.
You brought up just one: what is a qualified dividend. You would need to ask the company in whose stock your invested to determine if their dividends are quilified by IRS rules (the fact that it is a drip is meaningless), if you don't get a specific answer, I would err on the side of non-qualified. same for any dividend in an RRSP (if not deferring). You would need to determine what portion is qualified (an impossibility for a mutual fund). Even cap gain mutual fund distributions could be considered ordinary income by IRS. You also have the issue of Cdn currency held inside or outside an RRSP accruing 'currency gains/losses' which IRS considers other income, when it is 'sold' to buy investments.
The rule of thumb on exchage rates is: if you do periodic transactions, use an average, iff you do occasional transations, use date specific. If it asks for year-end, use Dec 31st. So in your son's case, if he made monthly contrib, he would determine the US value of the contribs with a yearly average, if he also made a withdrawl, or got a dividend on a specific date, he would value that dividend with date specific rate. When the form asks for year-end value (which is meaningless for any IRS purpose, btw) you should use the Dec 31 rate. Inconsistent? Just be consistently inconsisitent and you will be fine. that is why we have spreadsheets.
So you have 2 decisions to make. Whether or not your son should use FEIE-FTC (even if you use FEIE there is always other income that needs to be handled by 1116) or FTC-only (FTC is the way of the future for all US citizens in canada), and then whether to defer taxation on RRSP or wait.
After 20 years, I am severely cutting back on responses. Do not ask specifically for my help. There are a few others on this board that can answer most questions. All the best
Many thanks for your thorough explanations, nelsona. They are very clear. Unfortunately, he cannot use 1116 because he paid no Cdn tax at all, because he was a student and contributed to RRSP. Next year when he is working full-time he will still have unused RRSP and tuition room and I cannot bear to think what will happen then!
Because I've completed the worksheet for the FEI and still come up with tax owing, even if I defer the RRSP. I can deduct tuition because his university is FSA-accredited, and some medical expenses...that's all I can see so far. Is it possible I've missed something? I've never gotten into deductions and such before. But it states that you have to reduce the FEI amount by any excluded deductions. Did I subtract wrong or something? You did say he would owe at least some tax...
Again, any thoughts will be very appreciated.
Because I've completed the worksheet for the FEI and still come up with tax owing, even if I defer the RRSP. I can deduct tuition because his university is FSA-accredited, and some medical expenses...that's all I can see so far. Is it possible I've missed something? I've never gotten into deductions and such before. But it states that you have to reduce the FEI amount by any excluded deductions. Did I subtract wrong or something? You did say he would owe at least some tax...
Again, any thoughts will be very appreciated.
He is entitled to all the deductiuons that any US college kid would have (and so are you allowed any deduction a US parent would get).
Just a note that it is probably not the wisest use of RRSP contribution room in years when he has little income. The usual cut-off is about $30,000 before RRSP makes sense. build up the contribution room and use it when it actually means something.
Forget claiming RRSP deductions in canada until he is at least in the second tax bracket, after using up tuition, etc. he could make the contributions now, I suppose, and take the deduction in canada when iot makes more sense, not now. He is in effect putting RRSP to save little or no tax in canada and actually adding tax in US. Doesn't sound to savvy, does it?
The notion of having low wage earners put money in an RRSP is a scheme dreamed up by RRSP managers. Now you see why it doesn't work, never mind the added complication of US angle.
As I said earlier, FEIE is now designed to tax you a little on every dollar you you do not exclude. You have to get out of the old FEIE mindset. it is more of a tax reduction than an income exclusion.
I really find it hard to fathom a circumstance, as a student working part-time, where he is not taxable in canada but taxable in the US.
Just a note that it is probably not the wisest use of RRSP contribution room in years when he has little income. The usual cut-off is about $30,000 before RRSP makes sense. build up the contribution room and use it when it actually means something.
Forget claiming RRSP deductions in canada until he is at least in the second tax bracket, after using up tuition, etc. he could make the contributions now, I suppose, and take the deduction in canada when iot makes more sense, not now. He is in effect putting RRSP to save little or no tax in canada and actually adding tax in US. Doesn't sound to savvy, does it?
The notion of having low wage earners put money in an RRSP is a scheme dreamed up by RRSP managers. Now you see why it doesn't work, never mind the added complication of US angle.
As I said earlier, FEIE is now designed to tax you a little on every dollar you you do not exclude. You have to get out of the old FEIE mindset. it is more of a tax reduction than an income exclusion.
I really find it hard to fathom a circumstance, as a student working part-time, where he is not taxable in canada but taxable in the US.
After 20 years, I am severely cutting back on responses. Do not ask specifically for my help. There are a few others on this board that can answer most questions. All the best
I would revisit his Cdn return at this point. They should all be done together of course.
The things you want to be most carefule about are dedutions that are Cdn-only, like RRSP, and US-only, like mortgage interst or foreign earned income. These do not necessarily give you the full return that they were intended to give, so one should not view them as normal US-only or Cdn-only filers would do.
His RRSP dedution is a no-brainer: contribute if he feels like it now, but use the deduction when its worth something. His tuition is another. There are certain rules to follow on when he can and when he must use these, but there is some flexibility. Use them when they will reduce his cdn tax most effectively, not so much so that they outstrip his US tax deductions.
Look more closely at the normal deductions available on 1040. many US foreign filers have been lulled into the notion that FEIE and the standard deduction takes care of everyrthing. It no longer does. Tuition, hope credit life credit are all used by students to eliminite US tax.
You also have to look at your filing situation to see if you should or should not be claiming him as a dependant. His paying a little tax now could leead to a larger deduction for you, if needed.
Its just not simple anymore.
The things you want to be most carefule about are dedutions that are Cdn-only, like RRSP, and US-only, like mortgage interst or foreign earned income. These do not necessarily give you the full return that they were intended to give, so one should not view them as normal US-only or Cdn-only filers would do.
His RRSP dedution is a no-brainer: contribute if he feels like it now, but use the deduction when its worth something. His tuition is another. There are certain rules to follow on when he can and when he must use these, but there is some flexibility. Use them when they will reduce his cdn tax most effectively, not so much so that they outstrip his US tax deductions.
Look more closely at the normal deductions available on 1040. many US foreign filers have been lulled into the notion that FEIE and the standard deduction takes care of everyrthing. It no longer does. Tuition, hope credit life credit are all used by students to eliminite US tax.
You also have to look at your filing situation to see if you should or should not be claiming him as a dependant. His paying a little tax now could leead to a larger deduction for you, if needed.
Its just not simple anymore.
After 20 years, I am severely cutting back on responses. Do not ask specifically for my help. There are a few others on this board that can answer most questions. All the best
waiver of penalty
Hi,
I find I may be able to give some help instead of always being on the receiving end.
For people filling out their Foreign Earned Income Worksheets--and finding they owe tax for the first time--at least there's no late penalty if the tax is $1,000 or less. (Even if it's over $1,000, they will waive the penalty this year, as long as it's due to the new rules.)
On the IRS website, they said,
[quote]Notice — Waiver of estimated tax penalty for certain taxpayers living abroad
If you claim the foreign earned income exclusion or housing exclusion on Form 2555 or Form 2555-EZ, the Tax Increase Prevention and Reconciliation Act of 2005 made changes to the tax law that may affect your 2006 tax liability. [u]The IRS will waive the 2006 estimated tax penalty to the extent the underpayment of any installment is attributable to changes made by the new law.[/u]
For more details, see Notice 2007-16 ( download version - PDF or online version - HTML).
To request a waiver, follow the instructions under Waiver of Penalty in the 2006 Instructions for Form 2210.[/quote]
I find I may be able to give some help instead of always being on the receiving end.
For people filling out their Foreign Earned Income Worksheets--and finding they owe tax for the first time--at least there's no late penalty if the tax is $1,000 or less. (Even if it's over $1,000, they will waive the penalty this year, as long as it's due to the new rules.)
On the IRS website, they said,
[quote]Notice — Waiver of estimated tax penalty for certain taxpayers living abroad
If you claim the foreign earned income exclusion or housing exclusion on Form 2555 or Form 2555-EZ, the Tax Increase Prevention and Reconciliation Act of 2005 made changes to the tax law that may affect your 2006 tax liability. [u]The IRS will waive the 2006 estimated tax penalty to the extent the underpayment of any installment is attributable to changes made by the new law.[/u]
For more details, see Notice 2007-16 ( download version - PDF or online version - HTML).
To request a waiver, follow the instructions under Waiver of Penalty in the 2006 Instructions for Form 2210.[/quote]
2210 was new subject / FEIE Worksheet Questions
I'm sorry, I meant to post the 2210/waiver as a new subject.
I found it while researching tuition and other deductions, and trying to figure out how to fill out the FEI Worksheet.
I'm concluding we have to use the FEIE and Worksheet because my son owed no Cdn income tax in 2006--and so there would be no Cdn tax to use as a Foreign Tax Credit. Is that reasoning correct? (Nelsona, you were wondering why he paid no Cdn tax--it was because he had unused tuition and RRSP room from previous years which reduced his taxable income to zero.) (And thanks for the advice about RRSPs for young people. There is one good thing, though--it has really shown him how quickly savings can build.)
Also--In Step 1 of the Worksheet, I can't seem to tell if I'm supposed to include the standard deduction, in arriving at the figure to enter from line 41. I always used to, and there's room to put it right on line 40. But somewhere they say you can only take the standard deduction if you don't take any itemized deductions. Does that apply to the Worksheet?
I found it while researching tuition and other deductions, and trying to figure out how to fill out the FEI Worksheet.
I'm concluding we have to use the FEIE and Worksheet because my son owed no Cdn income tax in 2006--and so there would be no Cdn tax to use as a Foreign Tax Credit. Is that reasoning correct? (Nelsona, you were wondering why he paid no Cdn tax--it was because he had unused tuition and RRSP room from previous years which reduced his taxable income to zero.) (And thanks for the advice about RRSPs for young people. There is one good thing, though--it has really shown him how quickly savings can build.)
Also--In Step 1 of the Worksheet, I can't seem to tell if I'm supposed to include the standard deduction, in arriving at the figure to enter from line 41. I always used to, and there's room to put it right on line 40. But somewhere they say you can only take the standard deduction if you don't take any itemized deductions. Does that apply to the Worksheet?
If he had sufficient tuition to reduce his income in canada, then he can do the same in US.
Am glad you realize how little you saved in taxes by claiming his RRSP contributions now. I hope you will be able to undo the deduction, pay alittle Cdn tax, use that tax to pay nothing in US, and then use the RRSP contributions he made later. I think you can.
As to the dedution, it either/or.
Am glad you realize how little you saved in taxes by claiming his RRSP contributions now. I hope you will be able to undo the deduction, pay alittle Cdn tax, use that tax to pay nothing in US, and then use the RRSP contributions he made later. I think you can.
As to the dedution, it either/or.
After 20 years, I am severely cutting back on responses. Do not ask specifically for my help. There are a few others on this board that can answer most questions. All the best
Breakthrough!
I will definitely be using the 1116 for myself, thanks to nelsona's encouragement.
I've finally, just today, had a breakthrough in understanding how these pieces go together, also thanks to your explanations and nudges in the right direction. I was able to exclude his income, declare his RRSP (small) earnings (i.e. instead of deferring them), and he still didn't have any tax owing, just as you suggested. Thank you very much, nelsona.
I've finally, just today, had a breakthrough in understanding how these pieces go together, also thanks to your explanations and nudges in the right direction. I was able to exclude his income, declare his RRSP (small) earnings (i.e. instead of deferring them), and he still didn't have any tax owing, just as you suggested. Thank you very much, nelsona.