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Terry Ritchie Podcast: U.S. Tax Issues for Canadians

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Minimizing liability when paying income taxes can be complicated for the nearly 1 million American citizens living in Canada. Terry Ritchie, Cardinal Point Wealth Management Vice President, recently shared his expertise on this topic with Financial Planning for Canadian Business Owners podcast host Jason Pereira.

From the tax definition of U.S. resident and income tax filing requirements to tips for setting up businesses and incorporating in Canada, Terry and Jason cover numerous topics of interest to Canadian entrepreneurs who are also residents of the United States.

In the nearly one-hour episode, you’ll also learn:

  • The potential penalties for not filing income taxes
  • Tax changes that occurred when Trump became president
  • Canada and U.S. homeowner tax differences
  • The importance of tax compliance
  • The effects of tax debt on U.S. passports
  • Much more

Check out the podcast and complete transcript of Terry and Jason’s conversation here.

Terry Ritchie
Terry Ritchie

Mitigating Exchange Rate Risk: Effective Strategies

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Where do you see the exchange rate going? This is a common question amongst our client base, many of whom enjoy a cross border lifestyle.  In fact, as Americans living in Canada may have noticed, the exchange rate is right up there with hockey and the weather in Canada’s national conversation.

The trouble is, accurately predicting the exchange rate is exceedingly difficult over both short- and long-term periods.  Even amongst currency analysts, who are the experts in this field, there is usually no consensus, a lone exception possibly existing when the loonie is trading at extreme values (either above par, or at 60 cents on the dollar).

The loonie is not currently at either extreme, but it has been volatile.  It fell about 8% against the greenback in 2018, rose significantly in January 2019 and moved lower through March.  Why is it so volatile, and why is it inherently difficult to predict the direction of the exchange rate?  The rate is impacted by more than one factor, which may push it in opposite directions.  For instance, the loonie is sometimes described as a petro-currency, driven by the price of oil.  As the price of oil (which is priced in USD) increases, all else being equal, the Canadian dollar would also increase relative to the US dollar.

The loonie is also driven by the differential between US and Canadian interest rates.  If rates on Canadian bonds are higher than those available in the US, then investors from outside Canada will tend to invest more money in Canada.  To purchase these investments, they need to convert their money into Canadian currency, driving the demand for loonies upward. This raises the value of the loonie relative to the US greenback.

It’s certainly possible to have the price of oil and the interest rate differential between Canada and the US pushing the exchange rate in opposite directions.  In the situation where oil prices are declining yet Canadian interest rates are rising relative to the US, it’s an open question which factor will have more impact.

Aside from these types of macroeconomic currency catalysts, there’s a school of thought that looks at what the value of a currency “should” be, based on equalizing what money can buy in various countries.  This is known as Purchasing Power Parity.  On this basis, the Canadian dollar is undervalued and should be worth somewhat more than it is now.  Unfortunately, it can stay this way for years, and does not spend much time at parity.  As a result, this metric is interesting but not necessarily any more helpful than other foreign exchange predictions for long term planning.

Given the notion that experts and scholars cannot make accurate predictions, how can cross-border financial planning be undertaken, and investment portfolios designed, for clients with assets in both currencies domiciled on either side of the border?  Financial planning is, to some extent, the practice of making assumptions about the future in order to provide clients with a picture of how that future will unfold provided the assumptions are perfectly correct.  As a result, financial plans are best presented with the caveat that they need to be refined over time to accommodate revisions to the assumptions as conditions change.

Unfortunately, the foreign exchange rate over the client’s lifetime is not the only unknown variable to consider.  Future rates of inflation and taxes on both sides of the border, as well as returns on investments in the stock and bond markets, are critical inputs.  Since the actual future values for these variables are uncertain, risk management tactics are utilized in portfolio design to reduce these risks.  This is equally true when it comes to currency risk.

One important consideration in cross-border wealth management is hedging investment securities into the currency of the country where retirement income will ultimately be spent.  It is often argued, correctly, that currency fluctuations tend to even out over the long term, and there is a financial cost to hedging strategies.  However, over the short term, those fluctuations can have a significant impact on investment portfolios and the income they provide.  While this extra layer of volatility can be worrisome for clients at any stage of life, it becomes increasingly critical when it has a direct impact on the amount of retirement spending a client can do from one year to the next.  A cross-border wealth management firm like Cardinal Point will use a prudent hedging strategy to manage the costs and benefits appropriately.

In addition, where possible, migrating assets over time into the client’s expected currency of residence in retirement can make a lot of sense.  For example, Americans working in Canada who plan to move back to America in retirement may hold their RRSPs in US dollars. The result is the minimization of the currency impact they experience long term.  Reducing the variability of future returns based on  exchange rate risk brings a dimension of certainty into an uncertain future.

Finally, it’s important to pay attention to the costs of converting money from one currency to another.  These costs can be 2% or more of the amount of money being converted.  If there is an ongoing need for a certain currency, a bank account denominated in the currency can be used to meet this need.  It’s best to minimize the movement from one currency to another, which can occur when money is moved between bank accounts, or a credit card issued in one country is used outside that country.  Where the need for conversion exists, using a specialized service provider such as OFX can result in significant savings on the transaction.

The exchange rate between the US and Canadian dollar is a significant source of risk for many clients. For Americans living in Canada and Canadians living in America, working with a cross-border financial planning firm is a prudent way to manage this significant financial and emotional process.

Terry Ritchie featured in The Insurance & Investment Journal article, Managing Cross-Border Clients

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From the Insurance & Investment Journal article:

Managing cross-border clients is a challenging area for advisors that requires thorough knowledge on how to handle life insurance, investments, taxes and pensions while respecting two countries’ rules and regulations.

The Insurance and Investment Journal spoke to U.S-Canada cross-border expert Terry Ritchie, a director at Cardinal Point Wealth Management, who’s specialized in the field for more than 25 years to find some answers. He says if you don’t have knowledge or experience it is very easy to mess things up for your client.

Read the article here

Managing Your U.S. Revocable Trust When Moving to Canada

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Affluent individuals living in the United States often use a U.S. revocable living trust (RLT) for estate-planning purposes. Such a trust provides confidentiality and flexibility in how assets are managed, as it eliminates the specter of probate.

A revocable living trust is transparent for U.S. income, gift and estate-tax purposes. The individual who transfers (settles) property to the trust is also its trustee and beneficiary. The trust is considered a U.S. grantor trust, which is ignored for U.S. income tax purposes. All income, losses and expenses are claimed on the individual’s personal U.S. tax return.

Moving to Canada: Canadian tax issues and administrative burdens
For individuals moving to Canada (both Canadian and U.S. citizens), continuing to hold a U.S. RLT will present tax and administrative challenges. Under Canadian tax laws, once the trustee(s) become residents of Canada, the trust will be considered a separate taxable entity and will be treated as a Canadian resident trust. This will then require the trustee(s) to not only file a Canadian Trust return but also to pick up all of the income earned by the trust on their personal Canadian and U.S.  tax returns.

Although foreign tax credits can be used to reduce and/or eliminate double-taxation issues, continuing to hold the U.S. RLT complicates tax filings. Further, the trust would have both a Canadian and U.S. cost basis that would have to be tracked and reported. The Canadian basis would be equal to the value of the assets within the trust on the day the trustee(s) moved to Canada. The U.S. cost basis would be equal to the original value of the assets at the time they were acquired.

In some cases, an exception exists under Canadian tax law that allows the taxpayer to deem all the income and capital gains/losses associated with the trust property as taxable to the taxpayer as an individual, effectively making the trust disregarded for both U.S. and Canadian tax purposes. Under this exception, there would be no double taxation on income earned by the trust during the taxpayer’s lifetime.

Double Taxation at Death
Double taxation issues become a greater concern if the trustee happens to die as a Canadian resident after the trust had been in existence for 21 years. Under this scenario, the trust would form part of the trustee’s estate and, depending on the size of the estate, U.S. estate tax could be payable. In Canada, the trust would also be taxed once the assets were sold on or after the 21st year anniversary of the trust. There would be no foreign tax credits available to offset these two taxes, which could result in double taxation.

Subject to Canadian departure tax
Meanwhile, U.S. citizens temporarily living and working in Canada could be subjected to departure tax on their trust when they return to the United States. U.S. citizens are afforded a five-year period (See article: “Americans Exiting Canada: Understanding the Five-Year Deemed Disposition Rule”) living in Canada in which they are not subjected to Canadian departure tax upon a return to the United States. As stated earlier, because the trust is considered a separate legal entity from a Canadian tax perspective, it would not be granted the same five-year exemption from exit tax because it is not a personally owned asset.

Financial institutions unable to hold or administer trust
An additional complication, unrelated to the tax issues outlined above, is the fact that most U.S.-based financial institutions will not hold a U.S. RLT once the trustee becomes a resident of Canada.

Most U.S.-based financial institutions are not registered and licensed to oversee a taxable (or trust) investment account on behalf of a Canadian resident, even if that individual is a U.S. citizen. Many individuals try to get around this regulation by registering the U.S. RLT to a family or friend’s U.S. address. Not only is it illegal to misrepresent your residency, but it could also create tax issues because the IRS and state will continue to receive tax slips showing you live at a U.S.-based address.

Although it is a great estate-planning tool for those residing in the United States, a RLT presents many tax and administrative challenges once you move to Canada. For those individuals intending to live in Canada for the foreseeable future, it would likely be wise to unwind the trust structure before or soon after arriving in Canada. This would prevent any adverse Canadian income-tax consequences. At Cardinal Point, we assist individuals and families moving from the United States to Canada with their financial, tax and estate-planning needs. If you are moving to Canada and own a U.S. RLT, we can advise you on whether it is in your best interest to keep the entity intact or close it down.

Options for U.S. IRA Account Holders Living in Canada

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At Cardinal Point, one of the most frequent inquiries we receive is from prospective clients asking what they should do with their U.S. retirement accounts after a move to Canada. These individuals are often caught off-guard by their U.S.-based financial advisor or institution after learning that their investment accounts must go into restricted status or be permanently closed. The reason they are often given is that their U.S.-based advisors and related custodian can no longer maintain accounts registered to a Canadian address.

Many advisors and/or firms in the U.S. – even some of the largest – are not properly registered and licensed to provide investment advice for a client living in Canada (even if the client is a U.S. citizen). In fact, there are few U.S.-based firms that carry the proper licenses and registrations to be able to service taxable, IRA or 401(k) accounts held by Canadian residents. And because of the additional rules and compliance requirements associated with servicing a client physically living outside of the United States, many U.S.-based firms have policies against providing services to non-U.S. residents.

The situation is equally troubling when an individual looks to a Canadian financial advisor to help. Yes, these advisors carry the proper Canadian securities licenses and they can manage accounts domiciled in Canada. But because they are not registered in the United States, Canadian advisors cannot oversee a U.S.-based retirement account. The situation leaves the Canadian resident frustrated and with few options for what to do with their U.S.-based retirement account.

Unfortunately, some advisors have tried to find workarounds that are not only illegal but not in the best interest of the client. Over the years, prospective clients have shared with us the “advice” that they have received from both U.S. and Canadian advisors. In the United States, these suggestions include leaving an old U.S. address on file or using a friend’s or family’s U.S. home address. To the advisor’s compliance officer and firm, it makes it appear as if the client is still residing in the United States. Not only is this illegal under U.S. securities laws and very likely against company policy guidelines, it could also suggest to the U.S. state in which the account is held, that the client is still a tax resident of that state. Given some of the fiscal challenges facing many U.S. states, we have seen state tax authorities use this as a phishing expedition to generate or pursue more tax revenue. In Canada, frequently given advice includes selling out the U.S. retirement account and moving the proceeds to Canada, so that the Canadian-based advisor can manage the assets. Simply following this advice without fully understanding or determining the tax impact of such a move, can be costly and harmful.

So what options are there for Canadian residents with U.S. retirement assets? While it may seem like a no-win situation, there are options available. The first step is to find a qualified Canada-U.S. cross-border advisor that is registered and licensed to provide investment and financial planning advice in both countries. Although there are very few who meet these requirements, these cross-border advisors can not only legally manage your investment and retirement accounts in both countries but can also provide the accompanying financial, tax and estate planning services that are required for those individuals with investment assets and interests in both Canada and the U.S. To take it a step further, when choosing a cross-border financial advisor, make sure that they are bound by the fiduciary standard and not the less strict suitability standard used by most Canada/U.S. investment and bank owned firms. The fiduciary standard is the highest standard of care in the investment industry. As a fiduciary, the advisor must operate in a way that puts the client’s needs ahead of his or her own through a transparent and conflict-free service model.

Because there is no one-size-fits-all approach when it comes to addressing Canada-U.S. cross-border financial planning matters, a fiduciary-bound, cross-border advisor will take the time to properly understand your complete and unique situation. The advisor will then develop a comprehensive Canada/U.S. financial plan including options on how best to address your U.S.-based retirement accounts. In the case of a Canadian resident holding a U.S. retirement account, some of the factors that must be considered include but are not limited to the following: age of the client, likelihood of the client returning to live in the U.S. one day, size of the IRA/401k account, type of IRA (traditional vs. Roth), client tax situation, citizenship, U.S. estate tax exposure, future income needs and residency of beneficiary.

Once a thorough assessment of the client’s situation is completed, the advisor will likely recommend one of the following courses of actions if the individual holds a traditional or rollover IRA*:

  • Close out the IRA and withdraw the funds: Under this scenario, if the owner of the account is a Canadian citizen, there would be a 30% U.S. withholding tax applied to the withdrawal. (This tax can be reduced to 15% if there is a signed IRS W-8BEN form on file. It is important to note that we are finding an increasing number of U.S. institutions that do not honor or understand the role of a W-8BEN form.) Depending on the client’s tax situation, the account owner may be able to recoup some, if not all, of the withholding tax applied through the use of foreign tax credits. If the individual is a U.S. citizen, there is no mandatory withholding tax applied. If the plan owner is under the age of 59 ½, an additional 10% early withdrawal penalty will be assessed on the value of the distribution. The entire amount withdrawn from the IRA account would then be picked up as income for Canadian income tax purposes for Canadian tax residents. If you are a U.S. citizen, the amount would be picked up as income for Canadian and U.S tax purposes. Through the application of foreign tax credits, this form of double taxation could be eliminated. It is important to be very careful when considering redeeming the entire IRA/401k account because the tax treatment tends to not be beneficial in most client situations.
  • Close out the IRA and move the proceeds to an RRSP: If you are not a U.S. citizen or tax resident, under the right circumstances this might be a worthwhile option to consider. Under U.S. tax laws, transfers for an RRSP or RRIF cannot be made into a U.S. IRA. However, Canadian tax law does provide for the transfer of proceeds from a U.S. retirement account to an RRSP. Under Canadian tax rules, there are two provisions under the Income Tax Act that with proper planning, the transfer of IRA or 401(k) proceeds can be made to any existing or new RRSP without compromising one’s RRSP contribution room. That being said, although Canadian tax on the U.S. retirement account distribution can be reduced or eliminated, the U.S. treaty withholding tax of 15% – and the 10% penalty if it applies – cannot be eliminated or reduced. Therefore, if the Canadian wanted to contribute the gross amount from the U.S. retirement asset to a Canadian RRSP, they would have to provide the 15% amount themselves from other financial resources.
  • Leave the IRA account in the U.S.: For many account owners, this course of action makes the most sense given that the Canada-U.S. Tax Treaty allows a Canadian resident with an IRA to leave the account in the U.S. and receive the same tax-deferred treatment the individual would enjoy if still living within the United States. Under this scenario, the plan owner could let the account grow until he or she is required to take out the annual Minimum Required Distributions (RMDs) after turning 72. At that time, a 30% withholding tax would be applied to each annual distribution received by a Canadian citizen (potentially reduced to 15% with a W-8BEN or recovered through the filing of a U.S. tax return and application of treaty benefit). For a U.S. citizen, no withholding requirements are necessary. The plan holder could continue to receive the RMD each subsequent year the same way the individual receives annual Canadian RRIF minimum withdrawals.Any withdrawals or distributions would be picked up as income for Canadian tax purposes (for Canadian residents) or as income for Canadian and U.S. tax purposes (for U.S. citizens or tax residents). Again, foreign tax credits up to a treaty maximum rate of 15% could be applied to eliminate this double taxation for U.S. citizens. There are additional benefits to holding the account in the United States. These include continued currency diversification (USDs), and less expensive investment options, as well as more variety of investment options, than can be found in Canada.* For the purpose of this short article, we are not listing the pros and cons of each scenario identified.

Many of the same tax rules outlined above for an IRA account would also apply to a 401(k) account holder who is a resident of Canada. However, we would suggest that the account owner consider “rolling over” the 401(k) account to an IRA account. The key benefit to completing this tax-free rollover is that an IRA account typically allows for more investment options within the plan.

If an individual is an owner of a Roth IRA account, the options are far greater and easier to navigate. This is because any withdrawal received from a Roth IRA after the account owner turns age 59½ is considered tax free for Canadian (if a specific first-year election is made when coming to Canada) and U.S. tax purposes. No withholding taxes are applied either. Like the traditional IRA, the account can grow tax deferred indefinitely for Canadian and U.S. tax purposes. Further, there is no RMD for Roths, meaning the account holder can take out as little or as much as the individual wants once turning 59½ years old.

A thoughtful plan must be put in place after a move to Canada. After all, many of us work hard our entire lives to save for retirement and a cross-border move shouldn’t jeopardize a person’s long-term financial health. When choosing an advisor, take the time to find a qualified individual or firm licensed to provide investment advice in both Canada and the United States. In addition, the advisor must bring a firm understanding of cross-border financial and tax planning matters and, just as importantly, the appropriate Canada-U.S. investment platform to support the recommended course of action.

Cardinal Point is a Canada-U.S. cross-border advisor firm with offices in Canada and the U.S. We specialize in assisting individuals and families with their investment, tax, financial and estate planning needs. We have the unique ability to manage U.S. retirement accounts on behalf of Canadian residents and operate solely under the fiduciary standard. If you wish to discuss the options for your U.S.-based retirement accounts, please feel free to reach out to us. One of our cross-border advisors would be happy to assist you.