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Clarifying the U.S. Minimum Distribution Rules

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There has been a lot of confusion regarding the U.S. minimum distribution rules, so this blog will serve as a written chronicle based on the current and proposed rules as of October 13, 2022.

Background
At a high level, the minimum distribution rules require you as the plan participant to begin taking minimum distributions when you attain the age of 70 ½, assuming you reached age 70 ½ by December 31, 2019. If you reached age 70 ½ after that date, you would instead begin required minimum distributions (RMDs) at age 72.

RMD

Summary and Takeaways

RMDs apply to assets of yours held in IRA, 403(b), SEP, SIMPLE, or 457 plan. They also apply to Roth accounts in 401(k), 403(b), and 457 plans, and inherited Roth IRAs. You’re required to start taking required minimum distributions (RMDs) at age 70 ½, if you reached that before 2020. Otherwise you must start RMDs at age 72.

As the Key Takeaways highlight, the rules can be complex and confusing, but failing to follow them can cost you penalties. That’s why this comprehensive blog outlines them for you in greater detail.

Key Takeaways

  • You may take more than the RMD without penalty.
  • How RMDs are calculated changes as you age, year by year.
  • Failing to follow the age rules can make you liable for a 50% excise tax
  • Your first RMD must be taken by a specific date, but there is an exception to this rule if you are still employed – and that rule also has complex parts and caveats
  • Calculating your RMD can be a complicated process, and has its own exception to the standard calculation method
  • Minimum distributions are still required after you die, with certain options available.

If you were already receiving RMDs as of December 31, 2019, you would continue on your current RMD schedule, increased by 1 each year for your increase in age. As an example, if you are age 75 on December 31, 2021, you will be age 76 on December 31, 2022, so you will use age 76 to calculate your 2022 RMD.

The minimum distribution rules are important, as if the RMD is not distributed by the required date, a 50% excise tax will be charged when you file your personal tax return. This penalty is based on the amount of the RMD, less any distribution that was taken during the year.

In all cases, you can decide to take more than your annual RMD without penalty.

RMDs apply to assets in a qualified plan, IRA, 403(b), SEP, SIMPLE, or 457 plan. RMDs do not apply to Roth IRAs during the owner’s lifetime; however, RMDs do apply to Roth accounts in a 401(k), 403(b), and 457 plan, as well as to inherited Roth IRAs.

Your first RMD must be taken by April 1st of the year following the year you attain age 72 (assuming you reached age 70 ½ after December 31, 2019). For each year thereafter, the RMD must be taken by December 31st. If you delay taking your first RMD until April 1st of the year following the year you reached age 72, your second RMD must still be taken by December 31st of that same year. Thus, you receive, and are therefore taxed on, two RMDs in that same year.

There is an exception to taking RMDs from qualified plans if you reach age 72 and are still employed by the plan sponsor of your qualified plan. In this case, you must take your first RMD by April 1st of the year following the year you cease employment with the plan sponsor of your qualified plan. This exception is not available to anyone who owns greater than 5% of the equity of the plan sponsor in the year they reach age 72.

Calculating Your RMD
The amount of your RMD is calculated each year by dividing the account balance as of the end of day on December 31st of the year preceding the distribution year by the distributed period determined according to your age as of December 31st of the distribution year from the Uniform Lifetime Table. The Uniform Lifetime Table can be found here.

The only exception to the Uniform Lifetime Table is if the sole designated beneficiary of your plan is your spouse and that spouse is more than 10 years younger than you. In this case, you can use the Joint Life Expectancy Table to calculate the RMD, which will result in a longer life expectancy, and therefore lower RMD amounts each year in comparison to the Uniform Lifetime Table.

As an example, Paul turned age 72 last year in 2021, and Paul’s spouse is within 10 years of his age. Therefore, Paul will be age 73 by December 31, 2022, and must use the Uniform Lifetime Table to calculate his 2022 RMD. Paul’s IRA balance was $1,000,000 as of December 31, 2021. In calculating Paul’s 2022 RMD, Paul uses age 73 (his age on December 31, 2022), which corresponds to a 26.5 distribution period per the Uniform Lifetime Table, and Paul will need to take an RMD of $1,000,000 / 26.5 = $37,735.85 by December 31, 2022, or else be charged a $37,735.85 @ 50% = $18,867.93 excise tax on his 2022 personal tax return.

Minimum Distributions for Inherited Accounts (Death Before January 1, 2020)
Minimum distributions are still required to be taken after you die. In the year of death, the RMD is calculated as it normally would be, and if you have not already received the RMD in the year of death, the RMD is instead paid to the beneficiary(ies) of your plan. After the year of death, there are different options available depending on who the beneficiary is, and if you die before or after RMDs began (RMDs would have already started if you reached age 70 ½ before January 1, 2020). These options are summarized below for those that have died before January 1, 2020:

Options After RMDs Begin (Death Before January 1, 2020)

Spouse beneficiary

 1. Distribute over the spouse’s remaining single life expectancy.

2. Roll over the plan balance to an IRA in the spouse’s name, and delay distributions until the spouse reaches age 72 (assuming spouse is not already age 70 ½ on December 31, 2019). The spouse then makes distributions based on their own single life expectancy.

Non-spouse beneficiary

 1. Distribute over the longer of:

  1. the remaining single life expectancy of the deceased, or
  2. the remaining single life expectancy of the non-spouse beneficiary.

2. Roll over the plan balance to an IRA in the non-spouse beneficiary’s name, and make distributions based on the longer of:
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  • the remaining single life expectancy of the deceased, or
  • the remaining single life expectancy of the non-spouse beneficiary.

No stated beneficiary

 1. Distribute over the deceased’s remaining single life expectancy.

Options Before RMDs Begin (Death Before January 1, 2020)

Spouse beneficiary

 1. Distribute over the deceased’s remaining single life expectancy.

2. Distribute within five years.

3. Roll over the plan balance to an IRA in the spouse’s name, and delay distributions until the spouse reaches age 72 (assuming spouse is not already age 70 ½ on December 31, 2019). The spouse then makes distributions based on their own single life expectancy.

Non-spouse beneficiary

 1. Distribute within five years.

2. Distribute over the remaining single life expectancy of the non-spouse beneficiary.

3. Roll over the plan balance to an IRA in the non-spouse beneficiary’s name, and delay distributions until the non-spouse beneficiary reaches age 72 (assuming non-spouse beneficiary is not already age 70 ½ on December 31, 2019). The non-spouse beneficiary then makes distributions based on their own single life expectancy.

No stated beneficiary

1. Distribute within five years.

Minimum Distributions for Inherited Accounts (Death After December 31, 2019)
The Setting Every Community Up for Retirement Enhancement Act (“SECURE Act”) originally passed the House in July 2019 and was approved by the Senate on December 19, 2019. The SECURE Act completely changed the RMD rules for inherited accounts, as all RMDs after death now follow the same rules regardless of whether RMDs had already started or not. The RMD rules changed under the SECURE Act and now depend on the type of beneficiary.

Types of Beneficiaries under the SECURE Act (Death After December 31, 2019)

Eligible Designated Beneficiary

Designated Beneficiary

Nondesignated Beneficiary

(also includes a stated estate, charity, and trust beneficiary)

Distribute over the remaining single life expectancy of the Eligible Designated Beneficiary.

If the Eligible Designated Beneficiary is a spouse, roll over the plan balance to an IRA in the spouse’s name, and delay distributions until the spouse reaches age 72. The spouse then makes distributions based on their own single life expectancy.

If the Eligible Designated Beneficiary is a minor child, the child becomes a Designated Beneficiary when they reach the age of majority.

Distribute within 10 years.**

If RMDs have already started, distribute over the deceased’s remaining single life expectancy.

If RMDs have not already started, distribute within five years.

You can list a beneficiary(ies) of your plan during your lifetime, or, if no beneficiary(ies) is expressly listed, the beneficiary(ies) is determined by the operation of the law or your Last Will.

An Eligible Designated Beneficiary is one of the following:

  • Surviving spouse
  • Minor child
  • Disabled or chronically ill person
  • Any other person who is less than 10 years younger than you

A Designated Beneficiary is a listed beneficiary that does not meet the definition of an Eligible Designated Beneficiary.

**The distribution within 10 years for a Designated Beneficiary has been a large topic of discussion and misunderstanding since the SECURE Act passed. Financial and tax professionals all initially interpreted the rules as a Designated Beneficiary not having to take any distributions in Years 1-9 after death, as long as the entire balance was withdrawn by December 31st of Year 10 after death. 

However, on February 23, 2022, the U.S. Department of Treasury released proposed regulations clarifying its interpretation of under the SECURE Act. These proposed regulations state that:

  • if you die before RMDs are required (before or at age 72), no distributions are required in Years 1-9 after death, as long as the entire balance is withdrawn by December 31st of Year 10 after death; but,
  • if you die after RMDs are required (after age 72), distributions are required in Years 1-9 after death, with any remaining balance being withdrawn by December 31st of Year 10 after death.

Therefore, for clarity, under these February 23, 2022 proposed regulations, the RMD rules are now as follows:

Options for RMDs under the SECURE Act (Death After December 31, 2019)
Eligible Designated Beneficiary Designated Beneficiary Nondesignated Beneficiary (also includes a stated estate, charity, and trust beneficiary)
Distribute over the remaining single life expectancy of the Eligible Designated Beneficiary.If the Eligible Designated Beneficiary is a spouse, roll over the plan balance to an IRA in the spouse’s name, and delay distributions until the spouse reaches age 72. The spouse then makes distributions based on their own single life expectancy.

If the Eligible Designated Beneficiary is a minor child, the child becomes a Designated Beneficiary when they reach the age of majority.

 If RMDs have already started, an annual RMD is required in Years 1-9, with the remainder of the account withdrawn in Year 10. If RMDs have already started, distribute over the deceased’s remaining single life expectancy.If RMDs have not already started, distribute within five years.

While the February 23, 2022 proposed regulations do not yet have the full force of law, we recommend proceeding as if these proposed regulations will stand as currently written. However, as a further update, on October 10, 2022, the IRS issued Notice 2022-53, which provides comfort to taxpayers subject to the 10-Year Rule who did not take RMDs in 2021 and/or 2022, that otherwise were required to do so under the February 23, 2022 proposed regulations, that no penalties (the 50% excise tax mentioned above) will be assessed. Unfortunately, conservative taxpayers who have already made distributions for 2021 and/or 2022 must continue to pay income tax on the amounts received. Therefore, there is no need to take 2021 and/or 2022 RMDs, and we hope to receive final regulations to provide clarity for the 2023+ RMD rules.

Finally, as a potential planning opportunity, if you do not have an Eligible Designated Beneficiary and want to avoid RMDs for your Designated Beneficiary(ies) for as long as possible, you should consider completing Roth conversions during your lifetime. As Roth IRAs are not subject to the minimum distribution rules during your lifetime, you are deemed to have died before taking an RMD, so an annual RMD is not required in Years 1-9, but the entire account must be withdrawn in Year 10. This planning should of course be weighed against having to pay tax during your lifetime to complete the Roth conversions.

Conclusion
The minimum distribution rules are complex as a result of the various changes over the past few years and the current February 23, 2022 proposed regulations. Taxpayers received some relief from 2021 and/or 2022 RMD penalties with the IRS’ October 10, 2022 Notice 2022-53. If you would like to review the governing rules and potential planning opportunities for your accounts that will be passed to your family and friends, or if you recently inherited an account and are unsure if a RMD is required and in what amount, please reach out to Cardinal Point.

How Much Risk is There in Bonds?

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A Wall Street Journal article a few weeks ago cautioned investors about the hidden risks in bonds. It has been a recurring headline we’ve noticed the last few months, particularly as yields on the US Treasury 10-year bond have increased from below 1% to about 1.60% currently. With economic activity and inflationary forces poised to rise this year, how much of a concern should investors have over their bond holdings?

bonds iStock

Summary and Takeaways

The current economy is rather unpredictable, and interest rates are rising. That’s why many investors wonder about the potential risk that bonds may represent. But headlines about bond risk should not cause undue worry. During almost any year you examine, the bond market overall tends to exhibit fairly low volatility. Bonds can also play an important role as ballast within your financial portfolio to keep it on a more even keel.

Key Takeaways

  • The total return on bonds is a combination of the current yield and any capital gains or losses on the principal value of the bond.
  • One way to mitigate risk in the bond market is to avoid exposure to those that represent credit risk – although such junk bonds may offer higher yields. Bonds with especially long maturation periods can also carry significant interest rate risks. 
  • The bond portion of an investment account may experience challenges, but its goal and role should stay the same – to provide a steady stream of returns and act to counterbalance to the inevitable ups and downs of the stock market. 
  • Over time and historically, bonds that are carefully and strategically selected based on your unique investment goals can add stability to your portfolio – even through tumultuous markets.

Rising yields do put a damper on the prices of previously issued bonds. If the prevailing interest rate is higher than those previously issued (and fixed) bond coupons, investors will pay less for those bonds in order for the total yield to be equal rather buying a brand-new bond at a higher rate or an older bond at a lower rate. In recent years like 2019 and 2020 when interest rates were falling, this was a benefit to bond holders who likely saw positive returns in the high-single digit range even as yields headed below 1%.

Total returns on bonds will be the combination of the current yield (the coupon divided by the price you paid for the bond) plus any capital gain or loss on the principal value of the bond. Over the last few decades, bond holders have generally benefited from positive capital gains as yields have fallen. As yields rise, any capital loss has the potential to reduce or even turn the total return negative.

Below we can see the experience of max drawdowns (the most that the investment fell at any point during the year) over the last 30 years for the Barclay’s Bloomberg Aggregate Bond Index—a representation of the entire bond market. A few aspects stick out. During almost every year, we see a drawdown at some point during the year of about 2% or more. However, very rarely, in only two of the 30 plus years, did we see drawdowns of over 5%. This illustration is meant to show that the bond market overall tends to have fairly low volatility.

Maximum Drawdown in Bonds

Weekly, January 1991 – April 2021

max-drawdown-bonds

Certain elements of the bond market may themselves have much larger exposures to different risks. Credit risk is extremely present in high yield, or junk bonds, and that can be seen by their significant declines in years when stocks are also meaningfully down, like 2008. High yield bonds declined in value by nearly 25% that year.

Bonds with significantly longer maturities, as measured by a duration, can also have significant interest rate risks. For example, in 2013 when the Federal Reserve was just hinting at starting to taper off their bond purchases following the recession of 2008 and the bond market experienced a ‘taper tantrum,’ long-term Government bonds declined by 13% for the year.

When we look at the overall bond market during years such as 2008 or 2013, we observed one slightly positive return and one slightly negative. Both are far away from the excesses of individual parts of the bond market.

At Cardinal Point, as detailed in every client’s Investment Policy Statement, we have long viewed the bond portion of an account as an area that can provide stability as its primary role. The yield and total return are helpful to an overall portfolio, but that must not come at a detriment to that portion of an account’s ability to preserve value when other areas are in distress, as we saw in spring of 2020. We utilize a variety of indexed and actively managed positions to have a dynamic exposure to the fixed income world and, on average, tend to hold bonds with a higher credit quality and a shorter duration than the overall Aggregate Bond Index.

When we see headlines about bond risks, we need to have the background and context that the risk in most investors’ overall bond portfolios is significantly less than the stock portion of their accounts. From January 1st –  April 25th of this year, with interest rates increasing by over a half a percent, the total loss reported on the Aggregate Bond Index was only -2.5%. While not an ideal way to start the year, in comparison, stock indexes have the potential to lose 2.5% in one day. Additionally, certain active Bond Managers have been able to limit their interest rate sensitivity, and shorter duration indexes have experienced even smaller loses during the same time period. Taking this into account, bonds are not likely the largest element of short-term risk to consider in your portfolio. Conversely, should yields remain at this level over a longer period of time, investors may look to re-evaluate the portion of their portfolio dedicated to this asset class.

As a comparison below, we have added in the maximum drawdown for a global stock market index over the same time. Here you can see that in virtually every year the drawdowns experienced in stocks dwarf those seen in bonds. Looking at a global stock market exposure, we have seen double-digit drawdowns in nearly half of the years, with nearly one sixth of those years seeing declines of greater than 25%.

Maximum Drawdown in Stocks and Bonds

Weekly, January 1991 – April 2021

max-drawdown-stocks-and-bonds

The bond portion of investment accounts may present a challenge in the coming years, however, the goal remains the same: to provide a return stream which allows investors to persevere through the inevitable swings of stock markets, while helping to meet the goals of the invested assets.

Indexes used: Bonds- Bloomberg Barclays US Aggregate Bond TR USD, Global Stocks- MSCI World NR USD. Sources:  Morningstar Direct 2020, WSJ, As Yields Rise, Beware the Hidden Risks in Ultralong Bonds, Jon Sindreu February 26, 2021

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. Emerging markets involve additional risks, including, but not limited to, currency fluctuation, political instability, 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.

What’s in Your Index?

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It is estimated that over $11 trillion USD is indexed or benchmarked to the S&P 500 index, or what many investors consider ‘the market.’ However, while that index does capture a good chunk of the public stock market capitalization in the U.S., it omits the rest of the globe. The criteria by which companies are included—which involve a secret selection committee and very general guidelines—are also somewhat murky.

Most recently, the S&P 500 index made news in this regard when it was decided that Tesla would finally be included beginning December 21, 2020. As a market capitalization weighted index, in which the largest companies represent the largest allocations, this was newsworthy because of Tesla’s meteoric rise over recent years. By market capitalization it is now somewhere around the fifth or sixth largest publicly traded company, larger than the likes of JP Morgan, Visa, Home Depot, and Johnson& Johnson.

Some have argued it does not always make sense to hold the largest weights in companies which are already the largest size, but research has also shown it has been a tough index to beat, especially as giant growth-oriented names have dominated performance over recent years. Currently the index is relatively concentrated at the top compared to previous years. In fact, the top five names of Apple, Microsoft, Amazon, Google, and Facebook represent 22% of the index. And each of those companies has done very well in 2020, with an average gain of 48% through Dec 12.

While the index does capture the majority of broad U.S. market stock exposure as measured by stock market capitalization, it lacks many medium and smaller listed firms as well as sometimes newer companies that are growing quickly. This year that meant it missed some major gains not only in Tesla, but also in many other impactful firms such as Zoom, Moderna, Docusign, and Square.

If we look at a more comprehensive, broad-based U.S. stock exposure such as the Vanguard Total Stock Market ETF (VTI), which holds about 3,500 stocks including all the ones mentioned above, 2020 performance through December 12 was 17.7% compared to an S&P 500 index tracker like the SPDR S&P 500 ETF Trust (SPY) of 15.6%. That difference will ebb and flow, but over longer periods such as the last 15 years, the greater universe of the Vanguard Total Stock Market ETF has helped performance, returning 9.8% annualized compared to 9.5% for SPDR S&P 500 ETF Trust. A measure of tax efficiency, as measured by Morningstar’s Tax Cost Ratio, also shows that the Vanguard Total Stock Market ETF was more tax efficient, with a tax cost of just 0.47% over that 15 years compared to 0.60% on SPDR S&P 500 ETF Trust.

We see the potential for similar situations around the world, specifically in Canada where the more common S&P/TSX 60 index holds, as the name implies, 60 of the larger Canadian-based public companies. That is well short of what we see in something like the Vanguard FTSE Canada All Cap ETF (VCN.TO), which holds over 180 Canadian companies. That meant any fund tracking the S&P/TSX 60 index missed out on some exposure to fast growing technology firms like Kinaxis or Lightspeed.

Certainly not every company yet to be included in the S&P 500 or the S&P/TSX will be good for performance, but our approach for every market—be it the U.S., Canadian, or International—is why not own all the companies as the building block for a well-diversified global portfolio?

Utilizing our core and satellite approach, we view broad, entire market exposure as the starting core positions for any client. We can then look to other areas of the market, such as academically proven factors, or small thematic tilts, to slightly overweight a particular area. In our view, this is the only way to ensure we will always have some exposure to the better performing stocks. Whatever the Tesla or Zoom is of 2021, we want to ensure we have some exposure to it.

1 S&P Down Jones Indices, S&P Global

All Performance data from Morningstar Direct, December 12th, 2020

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. Emerging markets involve additional risks, including, but not limited to, currency fluctuation, political instability, 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 prices rise and fall based on changes in an individual company’s financial condition and overall market conditions. Stock prices can decline significantly in response to adverse market conditions, company-specific events, and other domestic and international political and economic developments.

California Residents: Does Your Financial Advisor Tax-Manage Your RRSPs?

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California residents who hold RRSPs, LIRAs, RRIFs or other Canadian tax-deferred accounts are subject to a unique set of tax planning and reporting requirements.

california-flagUnlike most states, California does not allow Canadian retirement accounts to grow on a tax-deferred basis. And that can present a serious income-tax problem for residents of California, given the fact that the state taxes the annual income distributions (interest and dividends) and realized capital gains inside Canadian registered plans.

What are California’s Tax Rules?
California rules require its tax residents to include annual investment earnings on their Form 540. Unlike the taxpayer’s U.S. federal return, the State of California (Franchise Tax Board) requires that you pay tax annually on your RRSP earnings.

You would be responsible for including your interest (line 8), dividends (line 9) and capital gains (line 12) of Schedule CA. They will ultimately appear in Column C for additions to income. If you have a capital loss, the loss would be reported in Column B of line 12.

The State of California’s tax position on this matter is reported in Franchise Tax Board Legal Branch. Click here to view the documentation.

It can be difficult to avoid including this income for California State tax purposes, given that the state requires that the taxpayer’s complete tax return, including Form 8938, be included. This gives the Franchise Tax Board the ability to determine whether a taxpayer has an RRSP and has included the accrued income within their Form 540 return. To make matters worse, if a California resident were taking distributions from their RRSP/RRIF where Canadian withholding tax was being remitted to the Canada Revenue Agency (under the Treaty), this tax would not be eligible as a foreign tax credit for California State tax purposes. The state does not recognize, nor is it party to, the Canada—U.S. Income Tax Treaty.

What can be done to minimize tax?
Unfortunately and all too often, Canadian advisors overseeing Canadian retirement accounts are unfamiliar with California’s treatment of these accounts. What’s more, they do not offer investment strategies to ensure the management style and philosophy employed is uniquely mapped to California’s tax rules. And why would they? Their core clientele are Canadian residents with RRSPs, and not U.S. residents living in California. That is one of the reasons we suggest clients living in the United States, and especially California, work with a Canada-U.S. cross-border financial advisor.

At Cardinal Point, we strive to reduce taxable transactions inside clients’ Canadian retirement accounts through a tax-managed style of investing. First, we treat the account as if it were taxable (non-registered) rather than a traditional, tax-deferred retirement account. In doing so, we always consider the future tax consequences of each security selected. For example, an RRSP account being managed on behalf of a Canadian resident might typically include higher-yielding, income-producing securities. This makes sense under Canadian tax rules for residents of Canada because investment income inside an RRSP plan is tax-sheltered. In California, however, the exact opposite is true. Therefore, we select investment securities that attempt to limit large taxable transactions or distributions inside the account.

Another key aspect of tax managing a Canadian retirement account is employing tax-loss selling when possible. When a security with a capital gain is sold, we proactively sell a security in the account with an unrealized capital loss to offset the gain where possible. If a security in the account has a large unrealized capital gain, we may attempt to reduce the holding over a number of years to minimize taxes, versus selling out the entire position at once and incurring a hefty tax bill.

The ultimate goal is to tax manage the account to the greatest degree possible without compromising the integrity of the client’s overall investment strategy or performance.

Other Considerations for RRSPs
Aside from tax managing Canadian retirement accounts on behalf of California residents, we also provide the following strategies:

  • U.S. dollar-Denominated RRSPs: We have the ability to manage your RRSPs in U.S. dollars, eliminating the need to monitor the Canada-U.S. exchange rate.
  • Cross-Border Account Integration: We offer integration with your U.S. investment accounts so that the investment strategies of your Canadian and U.S. accounts complement each other.
  • Proper Tax Reporting: Our firm provides Canada-U.S. tax reporting and preparation services to ensure all IRS and state foreign account reporting and disclosures are done correctly.
  • Discharging Your RRSP: We advise on the best process, timing and tax strategy to distribute your RRSP.

California residents who hold Canadian tax-deferred accounts face a number of tax-planning and reporting challenges. In order to comply with the state’s reporting requirements, and preserve as much of your capital as possible, we strongly advise that you work with a qualified cross-border financial advisor. Please don’t hesitate to contact the team at Cardinal Point if you are interested in learning more.

Jeff Sheldon is a co-founder and principal at Cardinal Point, a cross-border wealth management organization with offices in the United States and Canada.

Options for your CAD Non-registered assets when moving to and/or living in the U.S

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The strong U.S. dollar has created new challenges for those moving to the United States from Canada—but understanding these challenges, and your options, can help you to navigate the financial transition as smoothly as possible.

canadiandollarHere’s the background. The Canadian dollar is currently valued around 0.80 versus the U.S. dollar, a big departure of 0.90 to 0.95 seen in the summer of 2014. With the currencies so closely valued in the past, many individuals elected to convert their bank and non-registered (taxable) investment-account funds to U.S. dollars, and move them to a U.S. bank or custodian.

After all, if you live in the United States and your living expenses are denominated in U.S. dollars, having much of your liquid net-worth in the local currency makes sense. Furthermore, converting and moving Canadian non-registered accounts to the United States simplifies tax and foreign-account reporting requirements. It also provides for better investment opportunities, including those that are more tax efficient. And it helps to simplify your financial and estate planning.

A Canadian dollar at 0.80 complicates things, however, as most clients naturally do not wish to convert funds at a 20% discount. So let’s look at the options available to individuals or families who do not want to convert their non-registered accounts to U.S. dollars.

OPTION 1: Leaving your Canadian investment accounts in Canada
If you work with a Canadian financial advisor, chances are they are not registered to provide investment or financial planning advice to a U.S. resident.

A financial advisor must always be licensed in the jurisdiction in which a client lives, regardless of the client’s citizenship or the country in which the assets reside. Thus, once you become a resident of the United States and ask your advisor to update your mailing address on file to your new U.S. address (never leave your old Canadian address on file: see this related article), one of three things will likely happen:

  1. Your advisor will inform you that they are no longer able to provide investment advisory services to your non-registered accounts, and that you must work with someone who is able to do so;
  2. Your advisor will explain that you can keep your accounts on the platform, but that they will be frozen and that no further trading or rebalancing can take place;
  3. Your advisor will explain that they are registered in the United States and can continue to oversee all investment-management services in your accounts.

To reiterate, most Canadian advisors are not registered in the United States. So the mostly likely scenarios are numbers one and two. In the event that your advisor fits the third scenario, you will want to make sure that their services and expertise extend beyond just providing investment management.

For example, when moving to, and/or living in the United States, clients face a host of cross-border planning complexities. A true cross-border advisor will help construct an integrated Canada-U.S. cross-border financial plan that addresses tax and estate planning matters in addition the management of your investment assets.

Now, if you decide to leave your Canadian non-registered accounts in Canada under one of the first two scenarios, there are number of important points to consider.

  • Drawbacks of Canadian funds. Canadian-traded mutual funds and exchange-traded funds (ETFs) are considered “not registered for sale” to U.S. residents. Even more importantly, they are likely to be considered Passive Foreign Investment Companies (PFIC). Earnings and dividends distributed by such vehicles are subject to the highest marginal tax rates on your U.S. income tax return. Download our whitepaper on PFICs  for further information.
  • Accounting hurdles. Canadian custodians do a poor job conforming to U.S. tax reporting requirements. For example, many do not prepare year-end tax reports that show long-term versus short-term capital gains. These reports are required if you are a U.S. resident. Further, many of the tax reporting forms Canadian custodians provide are denominated in Canadian dollars, which means your accountant will have to convert all taxable and reportable transactions to U.S. dollars when you file your annual U.S. tax returns. This additional work by your accountant can increase the likelihood of errors and lead to higher accounting and tax-preparation cost.
  • The Conversion Window. If your goal remains to convert your funds to U.S. dollars once the exchange rate improves, make sure the investment strategy put in place will accommodate a future currency conversion. For example, make sure you are not locked into investment products that must be held for a certain period of time. Also, make sure your investment accounts are not invested in volatile or speculative securities that are subject to sharp market swings. It would be unfortunate if, when exchange rates became attractive, your Canadian-dollar investment holdings were sitting at a loss due to poor market performance.
  • Tax-aware investing. Make sure your advisor is managing your account under an investment mandate that reflects your U.S. tax residency. As mentioned earlier, U.S. tax residents are subject to long-term and short-term capital gains rates. If you sell an asset that has been held for one year or less, any profit is considered a short-term capital gain, and is taxed at your ordinary income rate (up to 39.6%). If you sell an asset held longer than one year, any profit you make is considered a long-term capital gain, and is typically taxed at a preferable rate (15% or 20%). In Canada, there is no such thing as long- or short-term capital gain. Canada has just one capital gains rate, and Canadian portfolio managers are trained to oversee client accounts under this standard. Also, there are different types of investment securities, such as Canadian preferred shares, that are attractive investments from a Canadian tax standpoint but not from a U.S. tax standpoint. It is always in your best interest to confirm that the Canadian money manager or advisor can customize the management style of your portfolio to adhere to U.S. tax rules.
  • Reporting requirements. You will be subject to extra foreign account reporting requirements by the Internal Revenue Service. Because these accounts are domiciled outside of the United States, the IRS will require you to report specific information about them (account number, year-end value, highest market value in the tax year, etc.) on a form called the FinCEN Report 114. Additionally, you might likely have to file IRS Form 8938 – Statement of Specified Foreign Financial Assets as part of your Form 1040 filing as well. These increased reporting requirements are time-consuming and will likely lead to increased tax preparation costs.

Leaving your Canadian-dollar taxable or non-registered accounts in Canada once you become a U.S. resident can be done under limited scenarios. But in light of the considerations above, it certainly is not ideal.

Option 2: Moving your Non-Registered Investment Account to the United States
Moving your Canadian-dollar investment accounts to the United States will simplify financial and estate-planning initiatives, and will streamline U.S. tax reporting. But you still will face challenges. For one, most U.S.-based financial advisors will automatically want you to convert your Canadian-dollar accounts to U.S.-dollar accounts—which, of course, contradicts the goal of maintaining your holdings in Canadian dollars. The main reason U.S.-based advisors will recommend this is that their firm or its custodian does not offer multi-currency accounts. The only currency option they provide for investments is U.S. dollars. It is rare for investment firms to offer Canadian dollar-denominated accounts because there is little demand for them in the United States.

Those investment advisors that do offer multi-currency accounts may not know the Canadian investment market well enough to construct a proper investment portfolio. It is one thing to be able to open a Canadian-dollar-denominated account on behalf of a client. It’s another to be a financial advisor or portfolio manager with the knowledge base and training to build Canadian-based investment portfolios using Canadian-traded securities.

All too often, clients are left holding their Canadian-dollar investment account in cash because they cannot find a qualified U.S.-based investment manager to invest the assets.

The Cardinal Point Difference: Cross-border investment management
At Cardinal Point, we are registered to provide investment management and financial planning services in both Canada and the United States, without any restrictions or limitations. For clients who have investment accounts in both countries (RRSPs, Non-registered, IRAs, 401ks, Trusts etc.), we are able to construct integrated cross-border portfolios customized to the investor’s risk tolerance, needs and goals.

If you are an individual living in and/or moving to the United States and do not want to convert Canadian-dollar, non-registered assets to U.S. dollars, our experienced Canada-U.S. portfolio management team can help. We have the ability to invest your Canadian-dollar accounts on a U.S. custodial platform. Partnering with Cardinal Point to oversee the management of your Canadian-dollar non-registered accounts brings the following benefits:

  • Proper and customized U.S. tax reporting on Canadian-dollar investment assets
  • Multi-currency investment accounts supported by an investment team that provides Canadian-dollar and U.S. dollar asset management services
  • Flexible foreign exchange services
  • Understanding of U.S. tax management strategies on Canadian-dollar investment accounts
  • Additional cross-border financial, tax and estate planning expertise
    Please contact Cardinal Point to discuss your cross-border investment management and financial planning needs.

Jeff Sheldon is a co-founder and principal at Cardinal Point, a cross-border wealth management organization with offices in the United States and Canada.