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Residents of Canada: Tax Ramifications of being forced to liquidate a U.S. retirement account

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As mentioned in a previous article, many banks and brokerage firms are informing U.S. non-resident clients that they are no longer able to service their accounts and that their accounts have been restricted or even closed.  In that same article, we outlined the following:

U.S. citizens and Green Card holders who reside in Canada or anywhere else abroad would be considered to be non-residents for the purposes of these regulations.
These regulations are not new, but were not generally monitored or enforced.
Financial institutions have started to enforce these regulations much more diligently.
The options available to an individual for their taxable brokerage accounts once they have received notification that they are required to find another service provider were addressed in the above mentioned article. Individuals with tax-deferred accounts, such as an IRA or 401K, are being told much the same thing.  The account holder will generally be told that if they are not able to transfer the account to another service provider within a set period of time, the assets within the account will be liquidated and a distribution will be sent.  If a distribution from an IRA/SEP IRA/Roth IRA is received, you have 60 days to deposit the funds into another retirement account with a U.S. custodian or the distribution will become fully taxable.  Distributions from an inherited IRA/Roth/SEP IRA do not have a 60 day window.

For many, it is difficult to find an alternate service provider that allows a non-resident to maintain a retirement account in the U.S. Even if a new service provider can be found, it is possible that the new provider will restrict activity within the account, effectively freezing the account.  Because of these complications, Canadian residents may feel compelled to liquidate their U.S. retirement accounts.

For the majority of U.S. retirement accounts, a liquidation would have U.S. and Canadian tax implications for both U.S. citizens residing in Canada and Canadian citizens living in Canada.  A couple of common scenarios include the following:

A U.S. citizen owning a U.S. retirement account moved to Canada and became a tax resident of Canada.
A Canadian citizen who lived in the U.S. for a period of time on a work permit, and who contributed to a U.S. retirement account while living in the U.S., moved back to Canada and once again became a Canadian tax resident.
We will discuss each scenario separately, since the tax implications of the liquidation of the retirement account will be different for each scenario.

U.S. Citizen Becomes a Tax Resident of Canada

As mentioned in our previous article, when you establish income tax residency in Canada, for Canadian income tax purposes, you are deemed to have disposed of all of your property immediately beforehand, with some exceptions, for proceeds equal to the fair market value of that property at that time. You are then deemed to have acquired such property at a cost equal to such fair market value.  U.S. retirement accounts are one of the exceptions to this rule. As such, the retirement assets would retain their historical cost basis for both U.S. and Canadian tax purposes.

As a U.S. tax resident, a distribution from most types of U.S. retirement accounts would be taxed as ordinary income subject to taxation at marginal tax rates.  Distributions from Roth IRAs are not  taxable.  The maximum marginal tax rate is currently 37% (2018).  Depending upon circumstances such as the age of the recipient, there could potentially be early withdrawal penalties as well.

Canada will also tax the entire distribution from most U.S. retirement accounts.  The entire distribution is taxable even though an individual in this scenario did not previously receive a deduction on a Canadian tax return related to the contributions.  Distributions from Roth IRAs are not taxable in Canada.  The marginal tax rate would depend upon the province of residency. For example, a resident of Ontario would currently have a maximum rate of 53.53% (2018).  A foreign tax credit can be claimed in Canada in relation to the U.S. tax payable on the distribution.  Early withdrawal penalties are not eligible for a foreign tax credit.

Individuals in this scenario are generally subject to an overall tax rate upon liquidation equal to the Canadian tax rate.  The tax payable to the U.S., which is subsequently claimed as a foreign tax credit in Canada, is usually not sufficient to completely eliminate the Canadian tax liability.

Canadian Citizen Resumes Canadian Tax Residency

The second scenario is of a Canadian citizen previously living in the U.S. who moves back to Canada and resumes Canadian tax residency.

In this scenario, the U.S. requires a 30% non-resident withholding tax.  Due to the tax treaty between the U.S. and Canada, that rate can be dropped to 15% for periodic payments, but there is some debate about whether or not that applies to a liquidation event, and recently, service providers have been less inclinded to agree to the lower rate.  Because of this, we advise our clients to expect a 30% withholding rate from most providers.  In order to recuperate the other 15%, the filing of a U.S. non-resident income tax return would be required.  Note that recuperating the other 15% would not be required if the entire 30% withholding tax is claimed as a foreign tax credit on the Canadian tax return.  In the case of an early withdrawal, the penalty normally imposed would be included in the 15% or 30% tax, which is considered a final tax for U.S. tax purposes.

Canada will also tax the entire distribution from taxable U.S. retirement accounts in the same manner as was discussed in the earlier scenario.  A foreign tax credit can be claimed in Canada in relation to the U.S. withholding tax.

Individuals in this scenario are also generally subject to an overall tax rate upon liquidation equal to the Canadian tax rate.  The U.S. foreign tax credit is generally not sufficient to completely eliminate the Canadian tax liability.

A relatively common tax planning technique for individuals in this scenario is to roll funds from their IRA into a RRSP in an effort to defer taxation of the IRA income.  This strategy is now less attractive due to the application of the higher 30% U.S. non-resident withholding tax.  We would also point out that this strategy is generally recommended by service providers that do not have the ability to actively manage U.S. retirement accounts.  A more effective solution would be to find a service provider, such as Cardinal Point, that can actively manage the IRA and eliminate the need for a liquidation altogether.

The Cardinal Point Advantage

These examples highlight the complicated and negative tax implications involved with an unexpected liquidation of U.S. retirement accounts.  The main negative tax implication being that the full value of most retirement accounts becomes taxable upon liquidation.  We recommend that you avoid these unnecessary tax consequences by finding a custodian who is able to manage U.S. retirement accounts for non-residents of the U.S.  Cardinal Point has the unique registrations and ability to manage investment portfolios that include accounts in Canada and the United States.  As such, we have the ability to actively manage U.S. retirement accounts for our Canadian resident clients.

Cardinal Point has the cross-border financial planning, investment management, and tax expertise to ensure that our clients are able to maintain retirement assets in their country of origin, and to transition other assets from one country to another in a tax-efficient manner. Our clients receive tax planning as a part of their overall financial plan.

Why Invest Internationally?

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Diversification is the most important concept in investing, but also perhaps the least exciting. If anyone knew for sure exactly which one company or country would have the highest return in the coming year, there would be no reason to hold anything else. But while being able to predict markets with any certainty sounds great in theory, in practice nobody has been able to consistently outsmart the market. So what do you do if you can’t know for sure if Pepsi or Coke, or the US or Canada will be the best performer in the coming year? You diversify. This is especially important when it comes to financial planning.

While we may plan to retire in one country or have our peak earnings years in another, having broad-based global diversification can help you over the long run, even though in any give year or time period it can feel like it’s not benefiting you.

Stock Market Returns 2003-2006Let’s take an example of a Canadian investor who had a CAD account and was watching returns in the early 2000s. Between the start of 2003 and the end of 2006, the Canadian market far outpaced the US. You can see from the chart on the left that the annualized returns (in CAD) for Canadian markets was nearly triple the returns for US markets over that period.

Besides Emerging Markets, it would have been hard to see much reason to allocate any investments outside of Canada. And in fact, that’s much of what the Canadian and US investing media was telling you at the time- dump your US stocks, and buy Canadian and Emerging Markets! Yet moving to those markets solely and out of the US and International Developed markets would have been particularly painful shortly after in 2008, when  Canadian and Emerging Markets holdings would have underperformed compared to US markets, when viewed in CAD.

Stock Market Returns 2015-2017More recently, if we look at 2015-2017, Canada has delivered just half the performance of the US on an annualized basis, and well below the returns experienced in  International Developed and Emerging Markets.

As we can see on the chart below, the order of returns by region each year is essentially random. Trying to guess in advance each year which country or market segment will outperform will likely lead to simply buying what’s been hot in the last year and will often result in  disappointment. One area might do well for a number of years, as Emerging Markets did in the early 2000s, only to fall hard in 2008. US stocks did much better than Canadian stocks for 6 of the previous 7 calendar years, but underperformed significantly in 2016, and have experienced steeper declines this October.

Returns by Region

*2018 YTD is Jan 1 – Oct 27

Instead of guessing which country or region is going to outperform next, astute investors can realize many benefits by spreading their assets across the group of global stocks. Doing so  allows you to capture the returns of whichever market is doing best in that time period, and ensures you’re never exposed to just one market or currency. As you can see on the chart, a blended exposure to the different regions means you can reduce your year to year volatility, and this is before the introduction of bonds or other asset classes that may move differently than stocks.

Over the last 15+ years, each region we looked at had strongly positive returns. Standard deviation measures how much those investments went up or down over the years, with  Emerging Markets being the most volatile. The Sharpe Ratio measures how efficient each investment was by comparing the magnitude of the returns  to the amount of volatility experienced. US stocks looked pretty good during this time period, but they don’t beat the blend when it comes to reward per unit of risk.

Looking back to the chart of annual returns above, we can’t know what region will have the strongest returns over the coming week, month or year. Yet, when we look at the blended result, which made no predictions at all but simply followed a long-term asset allocation between the four regions, we saw the lowest volatility and a healthy return , resulting in the highest Sharpe ratio.  This indicates that the blended portfolio is a  more efficient stock allocation than holding any one region individually. This blog looked at these regions from the Canadian Dollar point of view, but the results and theory are similar from the US Dollar perspective.

The downside of diversification is that you will never be the best performer. There will always be some particular stock or area of the market that will do better than the whole of your portfolio. But by having a globally diversified portfolio, you’re likely going to be capturing some of those gains. At some points, like 2008 or recently in 2018, all markets may see losses, however diversification ensures that you’re not taking unnecessary risk by having all of your exposure in any one company, sector, or country.

Thinking back to the financial plan that is crucial to the ability to meet long term goals, the long-term growth rates assumed are already factoring in ups and downs along the way. Nowhere in a prudent investment plan is the need to try and predict or out guess markets, but key to the plan is being able to capture those market rates of return wherever and whenever they do occur.

Source: Morningstar Direct 2018. Canada returns represented by S&P/TSX 60 TR CAD, US returns represented by S&P 500 TR CAD, International Developed represented by MSCI EAFE NR CAD, Emerging Markets represented by MSCI EM GR CAD. Blended mix represents 33% in Canada, 33% in US, 23% in Intl Developed and 10% in Emerging Markets, rebalanced annually. Indexes are unmanaged baskets of securities that are not available for direct investment by investors. Index performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. All investments involve risk, including the loss of principal and cannot be guaranteed against loss by a bank, custodian, or any other financial institution

Stock Market Volatility Is Nothing New

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It’s common to hear about the long-term investment averages that we’ve all become accustomed to. Conventional wisdom says that over the long run stocks should earn something like 10% per year. And in that regard, the conventional wisdom is actually pretty good. Over the last 30 years through the end of 2017, the annualized return on the S&P 500 was 10.7%, and 9.0% on the S&P/TSX 60. Given great average annual returns on both markets, financial planning should be a piece of cake right?

Ah, but we know we don’t get that 10% every single year, right? It’s not like a bank savings account that pays out a steady interest stream every month. Some years are better, others are worse. This variability gives rise to measures such as standard deviation, a calculation that tries to paint a picture of how much volatility you will experience in an average year. For the two indexes, the standard deviations have been extremely close over that same 30-year time period; 14.0% on the S&P 500, and 14.1% for the S&P/TSX 60.

That means that for US stocks, in about two thirds of the years, we should experience a return of somewhere between -3% and +25%, if history is a good predictor of the future. In Canada that would mean a range of -5% to +23%.

Those seem like reasonable ranges for most years, however we know it’s the years that fall outside of those ranges that we tend to remember. When we look back on returns its easy to remember the boom times of the late 90s, for example 1996 when US stocks gained 23% and Canadian stocks were up 32%. It’s also impossible to forget some of the bad times, like 2008 when US stocks dropped 37% and Canadian stocks fell by 31%.

Yet what’s often lost in these long-term averages and outlier events to the good or bad side, is that year to year we actually see much more variation than you might think by just looking at the end of year numbers. Going back over that same 30 year period, the average intra year decline seen in both the US and Canada was about 13%. That means that on average, at some point during a calendar year, the stock market was in a correction phase- a decline of more than 10% from its high for the year. The chart below show the annual gains since 1988 for both the S&P 500 and the S&P/TSX 60 in blue and red bars, respectively. Below, the line graph shows the largest intra year decline for each year.

Annual Returns and Max Drawdowns

S&P 500 & S&P/TSX 60, 1988-2017

2018 Stock Market Volatility
2017 was noteworthy for having a slow and steady gain throughout the year. At no time in the US or Canada did we see markets fall by more than 5% from their previous highs. In fact, as you can see on the chart, going back to 2011, most of the years have seen smaller intra year declines than the average over the entire period.

Losses in a portfolio are never going to feel good. However, we should put the current losses into context. The recent volatility we’ve seen, with drops between 5% and 10%, is not only completely normal, but still below average for intra year market movements. In fact, it’s this uncertainly, or risk, that is a real part of why we expect higher returns in stocks than safer investments like bonds, CDs or GICs.

Also, it’s important to keep in mind that these volatile movements in the stock market are only one part of a diversified portfolio. By combining stocks in the US, Canada and the rest of the world with less volatile bonds, your allocation can be tailored to meet your investing needs.

Persevering through the short-term ups and downs are part of the price investors must pay to capture those long-term higher rates of return. Ensuring that you have the right amount of those less volatile components in a portfolio can help you stick to the long term plan you’ve set in place.

Source: Morningstar Direct 2018. Indexes are unmanaged baskets of securities that are not available for direct investment by investors. Index performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. All investments involve risk, including the loss of principal and cannot be guaranteed against loss by a bank, custodian, or any other financial institution.

 

Terry Ritchie featured in the Globe and Mail: Foreign Exchange

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Terry Ritchie gives his insights and tips when dealing with foreign exchange options.

From the Globe and Mail article:

“I’m not a big fan of the banks,” said Terry Ritchie, a financial adviser who works both sides of the Canada-U.S. border. “They’re great for convenience. But if you can take the time and wait a day or two, there are better bets.”

Read the article here

How a U.S. resident can receive tax-free alimony from a Canadian

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While most people know that alimony is normally taxable income to the recipient and tax deductible by the payer, in the case of cross-border taxes, alimony can be received tax free while the payer still gets a tax deduction.

Let’s look at an example where this would apply.

Sarah is a U.S. Citizen who has been transferred to Toronto for a job opportunity. While living in Canada, she meets and falls in love with John, a Canadian citizen. After a few years of dating, Sarah and John decide to get married and live together in Toronto. Five years into their marriage, due to irreconcilable differences, they decide to divorce. Sarah chooses to return to the U.S. to live close to her family. As part of the divorce settlement, John must pay Sarah alimony.

Since John is a Canadian tax resident, he will be able to deduct the alimony payments to Sarah on his Canadian tax return. But with the right cross border tax planning, Sarah can exclude her alimony from U.S. tax. How? By including specific language required by the IRS in the divorce agreement. In our couple’s case, they would include language along the lines that John agrees not to deduct the alimony payments for U.S. tax purposes. Since John is a Canadian tax resident only, he is still able to deduct the alimony on his Canadian taxes and is not affected by the agreement.

While this is a very simplified example – the rules to make this legitimate are more complex – the fact remains that in Sarah’s case, a U.S. resident can receive alimony tax free for U.S. tax purposes. In John’s case, he also gets to reap the tax benefits from this strategy, unless he decides to take up a job in the U.S. and become a U.S. tax resident.