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Canadian Deductibility of 401(K) Contributions and U.S. Deductibility of RRSP Contributions

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Are Your 401(K) Contributions Deductible in Canada?

You might recognize this situation. You are a Canadian resident working in the USA on a TN visa. Your employer offers a 401(K) plan that includes a matching contribution. You know contributing to the 401(K) plan lowers your taxable income in the US. Does the same hold true for your taxable income in Canada?

Provided certain conditions are met, you may deduct, for Canadian tax purposes, the contributions you make to a 401(k) plan in the US.

For example, let’s assume you are a resident of Canada who is employed in the USA and you contribute to your employer-sponsored 401(K). Under the US-Canada tax treaty, your contribution to the plan (up to your remaining RRSP deduction room) will be deductible for Canadian tax purposes. But you need to be careful because your 401(K) deduction on your Canadian return is limited to your RRSP contribution room minus any other RRSP contributions. So if you’ve made RRSP contributions as well as 401(K) contributions, then you may have to defer some of the RRSP contributions you made and deduct them in a future year.

In addition, keep in mind that IRA contributions are NOT treated the same way as 401(K) contributions and are not deductible in Canada.

Are Your RRSP Contributions Deductible in the US?

In the above scenario, we discussed deducting 401(K) contributions for purposes of Canadian taxation. Now we turn our attention to whether or not contributions to an RRSP are deductible for purposes of US taxation.

John is a dual US-Canadian citizen who has been living and working in Canada for over 5 years. As a result, John files a Canadian tax return because he is a tax resident of Canada and he also files a 1040 return because he is a US citizen residing abroad.

If John makes a deductible contribution to a RRSP on his Canadian tax return, then will this contribution also be deductible on his US tax return? Generally, an RRSP contribution is not deductible on a US tax return.

There is, however, an exception under the Canada-US tax treaty that allows a RRSP deduction in certain situations. In particular, if the RRSP contribution is made via employee contributions to an employer sponsored group RRSP plan, then the contribution is deductible on the US tax return.

But there is a limit on how much you can contribute. Specifically, the RRSP contribution is limited to the lower of your RRSP deduction limit in Canada or your 401(K) limit (currently at $18,000 for those under the age of 50).

In addition, you will need to notify the IRS that you are lowering your taxable wages by the RRSP contribution. You do this by filing a Form 8833 with your US return and claiming an exemption under the tax treaty.

At Cardinal Point, we are here to assist residents on both sides of the border with their cross-border tax filing requirements and retirement planning scenarios.

Estate Planning: Uncle Sam’s Nasty Surprise for Non-U.S. Citizen Spouses

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Are you a U.S. citizen married to a non-U.S. citizen? Or, are you and your spouse both green card and/or U.S. visa holders living in the United States?

If so, then you’ll want to be aware of U.S. estate-tax rules that, without proper planning, can result in an outsized tax bill.

married-taxes Recently, we started working with an American client who has a significant estate and lives and works in the United States. His wife is a Canadian citizen and U.S. green card holder, but not a U.S. citizen. The couple does not have kids.

In a recent tax-planning session, our American client was shocked to learn that any gifts between he and his wife may be subject to tax rates as high as 40%. The same high tax rate may apply to any inheritance left by a deceased spouse to the surviving spouse. Our client’s surprise was understandable, because the rules are very different for couples who are both U.S. citizens.

Most Americans leave the bulk of their estate to their surviving spouse, because most of it can be transferred without tax consequences. In particular, under the “unlimited marital deduction,” if a person leaves his or her estate to a spouse, there is no estate tax on the transferred property, regardless of the size of the estate.

Simply put, the IRS is willing to wait until the second spouse dies before levying an estate tax. Similarly, married couples are free to make unlimited inter-spousal gifts without incurring gift taxes.

By the way, because of the U.S. Supreme Court’s recent DOMA decision, same-sex couples can now join heterosexual couples in transferring as much of their estate as they like to their spouse, free of gift or estate taxes. The catch is that both spouses must be U.S. citizens.

The IRS sees things differently when it comes to transfers in which one spouse is not a U.S. citizen. The “unlimited marital deduction” treatment does not apply to a foreign spouse because the IRS is afraid the non-citizen spouse will move to another country, thus avoiding U.S. gift and estate taxes altogether.

Without the availability of the marital deduction, current law permits the first $5,430,000 (adjusted for inflation) of assets to be transferred tax-free. In other words, an inheritance left to a non-citizen spouse is subject to a 40% estate tax after the $5,430,000 lifetime exemption is used up.

So what should you do if you are married to a non-citizen and your estate is above the exemption threshold?

Let’s use our clients as an example. The wife could become a U.S. citizen prior to the husband’s death. Or they could establish a qualified domestic trust (QDOT). A QDOT defers the estate tax until the death of the foreign spouse, and allows for an annual income stream to be paid to her. Moreover, it can buy time for the surviving spouse to acquire U.S. citizenship.

Gifting strategies can also be used to transfer a certain amount of assets to the non-citizen spouse each year (the 2015 limit is $147,000). This will gradually reduce the size of the U.S. citizen’s taxable estate while protecting them from federal gift-tax liability.

Alternatively, if certain conditions are met, our clients can take advantage of the marital credit under the Canada-U.S. tax treaty. This option, however, can’t be used in conjunction with the QDOT deferral.

As our clients learned, there are certain planning strategies and legal structures that, if set up in advance, can help cross-border couples avoid losing up to 40% of their wealth through unnecessary taxes.

If you would like more information about this topic, or to discuss your own unique situation, please contact us today for a confidential consultation.