Many people living in Canada work for U.S. employers under a specific immigration status known as Lawful Permanent Resident (LPR) with commuter status, commonly referred to as having a “commuter card.” This status allows Canadian residents to maintain their permanent residency in the U.S. while living in Canada and commuting to the U.S. for work. This status is a unique aspect of U.S. immigration law, catering to the needs of individuals who live close to the U.S. border and work in the U.S. while residing in Canada. This dual-tax residency scenario is convenient, but also gives rise to many cross-border financial planning considerations including cross-border wealth accumulation strategies such as a 401(k) in the U.S. and an RRSP in Canada.
Let’s first compare and contrast the main components of the cross-border retirement accounts.
A U.S. 401(k) plan is similar to an individual Registered Retirement Savings Plan (RRSP) in Canada in several ways, although there are also some key differences. Both are tax-advantaged retirement savings plans designed to help individuals build a nest egg for retirement. Here’s a comparison of the two:
Similarities:
- Tax-Deferred Growth:
- Traditional 401(k): Contributions are made with pre-tax dollars, reducing taxable income for the year. The money grows tax-deferred, and taxes are paid as funds are withdrawn during retirement. A Roth 401(k) is similar to a traditional 401(k), except contributions are made with after-tax dollars and earnings grow on a tax-free basis. In this article we are not addressing the Roth 401(k) as the rules are more complicated for the cross-border commuter to explain in a brief blog. (for more detailed information, please contact Cardinal Point.)
- RRSP: Contributions are also made with pre-tax dollars, lowering taxable income for the year. Like a traditional 401(k), the money grows tax-deferred, and taxes are paid when the funds are withdrawn.
- Contribution Limits:
- Both plans have annual contribution limits set by their respective governments. These limits are subject to change each year.
- Traditional 401(k): For 2024, the contribution limit is $23,000 for those under 50, with an additional catch-up contribution of $7,500 for those 50 and older.
- RRSP: For 2024, the RRSP contribution limit is 18% of the previous year’s earned income, up to a maximum of CAD $31,560 plus unused contribution room from prior years.
- Employer Contributions:
- Both plans often involve employer contributions or matching contributions, although this is more common in U.S. 401(k) plans.
- Traditional 401(k): Employers frequently offer matching contributions up to a certain percentage of the employee’s salary.
- RRSP: In Canada, this is typically seen in Group RRSPs, where employers may offer matching contributions. An employer’s contribution to your RRSP will result in a Pension Adjustment that reduces the amount you may contribute from your own funds to your RRSP in the following year.
- Investment Options:
- Both plans offer a range of investment options and vehicles, such as mutual funds, stocks, bonds, and more. The specific options offered to you will vary depending on the plan provider.
- Portability:
- Both accounts are portable, meaning the funds can be transferred to another retirement account if you change jobs.
Differences:
- Plan Structure:
- Traditional 401(k): This is an employer-sponsored plan, meaning it is set up and managed by an employer for their employees. While the employee chooses how much to contribute, the plan is tied to the employer.
- RRSP: An RRSP can be set up by an individual independently of their employer. While Group RRSPs exist and are employer-sponsored, individual RRSPs are entirely managed by the individual.
- Contribution Limits:
- Traditional 401(k): The U.S. government sets a flat annual contribution limit.
- RRSP: The contribution limit is based on 18% of the previous year’s earned income, up to a maximum cap.
- Tax Treatment on Withdrawals:
- Traditional 401(k): Withdrawals are taxed as ordinary income, and early withdrawals (before age 59½) are subject to a 10% penalty, with some exceptions.
- RRSP: Withdrawals are also taxed as ordinary income, but there is no specific age penalty for early withdrawals.
- Withdrawal Programs:
- Traditional 401(k): The U.S. 401(k) has provisions for the purpose of loans and hardship withdrawals under certain circumstances, which may allow access to funds with taxation or deferred taxation, but without penalties.
- RRSP: Canada offers specific programs like the Home Buyers’ Plan (HBP) and Lifelong Learning Plan (LLP) that allow individuals to withdraw funds from their RRSP tax-free for certain purposes, provided the funds are repaid within a specified timeframe.
- Required Minimum Distributions (RMDs):
- Traditional 401(k): RMDs must begin at age 73 if the individual is no longer working.
- RRSP: An RRSP must be converted to a Registered Retirement Income Fund (RRIF) or annuity by the end of the year the individual turns 71. RMD withdrawals must begin the following year.
While both the U.S. 401(k) and Canadian RRSP serve similar purposes as tax-advantaged retirement savings vehicles, the 401(k) is generally employer-sponsored, whereas an RRSP can be individually managed. Both offer tax deferral on investment growth, but they differ in structure, contribution limits, and certain rules around withdrawals and penalties.
As a “Commuter”:
What are the considerations of contributing to a 401(k)?
As a Canadian resident, it is unwise to contribute to a Roth 401(k), because Canada will tax the growth in the account even though the U.S. will not. However, a pre-tax 401(k) contribution may be advantageous, as long as the worker carries enough RRSP contribution room. This room can be found by reviewing your Notice of Assessment and/or “MyCRA account”. Here’s an example:
Steve is over 50, residing in Windsor, Ontario, and he commutes to Detroit, Michigan five days each week. Given his LPR Commuter status, he can legally work in the U.S. even though he is a Canadian resident. His U.S. employer offers a Traditional 401(k) plan as part of his benefit package. Steve made $130K USD in the previous tax year and his employer matches dollar for dollar up to 5% of his income. Therefore, if Steve were able to maximize his 401(k) contributions for the 2024 tax year, his total contribution would amount to $37,000 USD / $50,685 CAD equivalent as itemized below:
- $23,000 USD (standard contribution)
- $7,500 USD (catch-up contribution)
- $6,500 USD (employer’s matching contribution up to 5% of compensation)
Total: $37,000 / 0.73 (Current FX rate) = $50,685 CAD
If Steve executed these contributions as stated above, he would overcontribute by $19,125 CAD equivalent ($50,685 CAD – $31,560 CAD). Here’s the breakdown:
- $130K USD – previous years’ income / 0.73 (Current FX rate) = $178,082 CAD equivalent
- $32,055 CAD – 18% of previous years’ CAD equivalent income
Maximum deductible RRSP Contribution – The lesser of $31,560 CAD (2024 max) or $32,055 CAD (18% of previous years income).
If Steve chose to contribute to an RRSP instead of the 401(k) he would miss out on the matching contribution from his employer. But if he instead contributed $16,538 USD / $22,655 CAD to his 401(k) and received the company match of $6,500 USD / $8,904 CAD then he would retain the employer contribution or “free money.”
How does Steve reconcile U.S. 401(k) contributions on his Canadian tax return?
The CRA will gross up Steve’s income by the amount he and his employer contribute to the 401(k) and then allow for a foreign pension contribution as if it were an RRSP deduction. In this case, since CRA will not be receiving any RRSP contribution receipt, Steve’s tax preparer will reconcile the 401(k) contribution utilizing Form RC268. This tax form is used by Canadians who commute to the U.S. to perform employment services and are a member of their employer’s retirement plan in the U.S.
Contributing to a 401(k) instead of an RRSP could make sense for several reasons, especially if you have ties to the United States, such as employment or residency there, or long-term plans to retire in the U.S. Below are a few specific reasons why you might choose to contribute to a 401(k) over an RRSP:
- Employer matching contributions: Employer matching is essentially “free money” that boosts your retirement savings. For example, if your employer matches 50% of your contributions up to a certain percentage of your salary, you’re getting an immediate 50% return on that portion of your contributions, which is hard to beat.
- The 401(k) has a flat contribution limit ($23,000 for 2024, plus a catch-up contribution of $7,500 for those 50 and older), which may be higher than what you could contribute to an RRSP if your income is below a certain level.
- Reducing the number of foreign accounts that require U.S. tax compliance disclosures (FBAR, Form 8938): RRSPs require specific reporting if you are a U.S. tax resident such as an LPR with commuter status. Failing to comply with these requirements can result in penalties. However, if your non-Canadian property excluding the 401(k) has a combined cost amount that exceeds CAD$100K, you may need to complete and file Canadian form T1135.
Conclusion: You might choose to contribute to a 401(k) over an RRSP if you work for a U.S. employer. The 401(k) offers benefits like employer matching, higher contribution limits, and simpler tax planning for those with ties to the U.S. Each plan has its advantages, so the choice should align with your residency, tax obligations, and retirement plans. Retirement planning for “commuters” is just one aspect of cross-border wealth management to consider. There are many others that should be examined in a prudent manner. Working with a cross-border financial advisor such as Cardinal Point to coordinate and integrate your cross-border wealth management affairs within the context of the Canada-U.S. Income Tax Treaty is critical. Contact us for more information.