Distributing U.S. IRAs to U.S. and Canadian Beneficiaries

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lawman3966
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Joined: Sun Aug 10, 2008 12:09 pm
Location: Tacoma WA

Distributing U.S. IRAs to U.S. and Canadian Beneficiaries

Post by lawman3966 »

This question is related to a recent thread on cross-border inheritance, but goes in a different direction and thus warrants a separate thread.

I have an elderly mother living in Canada who is a Canadian citizen and former U.S. person - a former long-time green card holder. She has an estate worth about $ 1.2 million U.S., most of which is currently invested in Canada in the form of real estate and financial accounts. However, about $100K of her assets are in U.S. IRAs. The purpose of this thread is to determine optimal strategies for distributing the IRAs in light of three factors (1) the existence of beneficiaries in both the U.S. and Canada (one in the U.S. and two in Canada); (2) the general tax treatment of IRAS (by both countries); and (3) the cross-border inheritance tax issues.

My understanding is that bringing deductible U.S. IRAs to Canada causes the IRA funds to be taxed twice, once by the U.S. (since the account was funded with pre-tax money); and again by Canada once the funds are liberated from the U.S. IRA accounts. A normal estate process might well entail (1) withdrawing money from the U.S. IRA accounts and paying U.S. taxes thereon; (2) moving the money to Canada; (3) paying Canadian taxes on the now post-U.S.-tax funds; and (4) distributing the now double-taxed money to the beneficiaries, in both the U.S. and Canada.

Given that one beneficiary lives in the U.S., I am wondering if there's a more efficient way to distribute the IRA assets. For instance, is there a way to more directly transfer the IRA account itself, or funds from the IRA more directly to the one U.S. beneficiary and to thereby avoid having the IRA assets taxed two (and possibly three times if one counts the cross-border inheritance tax).

Another factor here is a desire to have the IRA accounts depleted and closed prior to the testator's death due to the cross-border inheritance tax issues. It's not clear whether that's going to be feasible or not. Since I don't know what distribution options exist for the IRA assets if conducting an inter-vivos transfer or upon management of the estate, it's hard for me to know what to recommend regarding IRA account handling. My first reaction was that the tax hit by the U.S. and Canada would be similar whether transferred during her life or upon her death. I have already heard the concern expressed that a rapid withdrawal of the IRA assets would incur heavy taxation (though I don't know if such taxation is any heavier than what the beneficiaries would ultimately pay).

If anyone knows of a way to efficiently transfer the IRAs more directly to the one U.S. beneficiary either on an inter-vivos basis or upon death, instead of going through the probate process (and the possibility of the assets being triple-taxed), I would love to know of it. Since the IRA assets are less than 1/3 of the estate, her will could be readily changed to suitably adjust the distribution of non-IRA assets to produce an equitable overall distribution.

Thanks in advance to any help the board can provide.
a18ion2
Posts: 3
Joined: Tue Apr 23, 2019 2:16 pm

Re: Distributing U.S. IRAs to U.S. and Canadian Beneficiaries

Post by a18ion2 »

I'm pretty sure you will find that the Canada-UK tax treaty will mitigate any double taxation of the IRA. If your mother is over 59 1/2 and closes out her IRA, there will be 15% withholding from the USA (she files a W8-BEN), but she will be able to take a credit for that tax on her Canadian return, so it will only be taxed once, even though the process is to pay first (in the USA) and then take the tax credit later when she files her Canadian return.

So, in the end, I don't think your concern about double tax on the current value of her IRA will materialize.

Separately, your mother might want to do some planning to take advantage of the fact that Roth IRAs have good features for a US beneficiary (if she left you the Roth IRA to you).

Since the IRA is a small part of her total estate, and that you are the only US beneficiary, she could do the following:

Convert her traditional IRA into a Roth IRA. She would pay tax as if she was redeeming the whole amount, and as in the first paragraph above, would pay a net tax in Canada (being the tax in Canada less the 15% US tax withheld from the rollover).

If adding the $100,000 IRA rollover in one year put her in a higher tax bracket in Canada than she wants, she could do it in bits (e.g. $25K pa over 4 years).

The money left in the Roth IRA would not suffer any further tax in the USA, but she would have to pay tax in Canada every year on any income earned in the Roth (as if it was a normal securities account). That’s no different than if she redeemed the whole lot and invested it with a Canadian broker (except fees are much higher in Canada)

Having set-up the Roth, she would nominate you as the sole beneficiary of the Roth. She does this not in her Will, but with the company managing the IRA. The account becomes a pay-on-death account in the USA and her Will has no bearing on how the money is distributed on her death.

Then, when she dies, the IRA company would contact you and offer to transfer the money to an Inherited Roth IRA under the US rules, and since you are a US taxpayer, and Roths are tax-free, you can then earn income in the Roth tax-free for the rest of your life!

You would be required to withdraw RMDs (Required Minimum Distributions) every year, but these are tax free. The RMDs ensure that the Roth IRA will be run down a bit every year, until you die. Technically, it works like this: if you were 45 and had a life expectance of 85, then there are 40 years left until you die. In the first year of your inherited Roth, you have to take 1/40th of the Jan 1 balance as an RMD. If the Roth is worth $100,000, then that’s $2,500 that you must withdraw (tax-free). The rest continues to grow for you tax free. The following year it’s 1/39th you have to take out. The next year 1/38th, etc. There’s always a balance left in the account until you die. And it all grows tax-free during that time.

That’s a way better option than you’re mother cancelling the IRA today, paying the tax, and sending you a $100,000 gift in cash. You can’t put that into a tax-sheltered account so easily.

Normally, a Roth IRA is treated the same in Canada as in the USA under the US-Canada Tax Treaty. But only for Roths set-up while not a Canadian resident. The rollover would mean setting up a new Roth IRA while she is a Canadian resident. So it won’t grow tax free for her in Canada even though you might read that Roth’s are tax free in Canada, too. Only for Yanks who emigrate to Canada with a Roth already in hand.

For US estate tax purposes, the value of the Roth would be included in her US non-resident estate. But given the US-Canada estate tax treaty provision, and that her estate is well under $11.4 million, then will be no US estate taxes due. But she will have the final Canadian capital gains tax to pay (i.e deemed disposal) in her last Canadian tax return on death. But, obviously, no Canadian estate taxes exist. And, obviously, this is a deemed disposal for Canadian income tax purposes only. The account is not actually liquidated in the USA. It’s just transferred to you.

You could say, what happens if she just leaves the traditional IRA as it is? You said your Mum was elderly. If she’s over 70 1/2 she should already be taking RMDs. If she isn’t, that’s a problem to address now. She needs to be taking RMDs every year after 70 1/2, and if she lives a long time, the account will be wound down to near zero that way. RMDs are not required for a Roth IRA, so once she converts it to a Roth, she can stop taking RMDs.

When she dies leaving a traditional IRA (instead of a Roth IRA), any amount later withdrawn by a US beneficiary (e.g. you) from a traditional IRA will be considered IRD (Income in Respect of a Decedent), and you will pay Federal and State taxes on the amount you take out. [You could have received a credit for any estate taxes paid, but none will be paid on her “small” estate.] So the full amount of the IRA, and all further growth will eventually be subject to both Federal and State income (if you live in a State with income tax).

Right now, because your Mum is not a resident in any US state, when she converts her traditional IRA to a Roth, she will only pay 15% Federal taxes. The future US beneficiaries will have neither Federal nor State income taxes to pay on IRD. So converting to a Roth will save future State taxes for US beneficiaries. So that by itself is a win. Never mind the further tax-free growth in the Roth.
QuantOfAsia
Posts: 78
Joined: Sun Apr 14, 2019 7:57 pm
Location: Hong Kong

Re: Distributing U.S. IRAs to U.S. and Canadian Beneficiaries

Post by QuantOfAsia »

Excellent thread - this is a growing problem as more of us have retirement accounts across borders.
a18ion2
Posts: 3
Joined: Tue Apr 23, 2019 2:16 pm

Re: Distributing U.S. IRAs to U.S. and Canadian Beneficiaries

Post by a18ion2 »

There's another problem that wasn't mentioned by the OP, and that's the treatment of a traditional IRA in Canada on the death of her mother.

The general problem is that in Canada, at death, there is deemed disposal of all assets. But not in the USA.

It looks like, at her death, she would normally have to pay full Canadian income tax on the value of her traditional IRA in her final tax return. And then, her US beneficiary will also pay US income tax on the IRA when they take money from it. Bad outcome! That results in the value of the IRA being taxed twice. Once in the mother's hand in Canada at death, and then in the son's hands in the USA as he takes withdrawals.

While this is a complex area, it seems the executor completing the mother’s final Canadian tax return could elect to defer tax on the IRA under ITA subsection 70(3). There would be no tax on the IRA in Canada on her death. Tax would then be due by the beneficiary as he withdrew the money. That works fine if the beneficiary is also in Canada. But what if the beneficiary is residing in the USA? Would he be liable in Canada to tax on the income deferred on his mother’s final tax return? How would this be enforced by CRA I wonder? Would CRA disqualify the section 70(3) deferral?

If the mother can defer Canadian tax at death using ITA 70(3) when the beneficiary is a US taxpayer, this seems like a hole in the ITA.

It’s probably safer if the mother has Canadian resident beneficiaries. If she appoints Canadian beneficiaries for a traditional IRA, the ITA 70(3) tax deferral will work in Canada. Unfortunately, few IRA providers will open accounts for Canadian residents. So they will likely require that the Canadian beneficiaries redeem the whole amount right away.

In that case, any 15% US withholding tax on the payment to the Canadian beneficiaries can be used as a foreign tax credit in Canada by those Canadians beneficiaries when they file their Canadian tax returns to report their share of their mother’s IRA. So, it won’t be double taxed this way.

Anyway, it’s all quite complex. I think it's better to convert to a Roth IRA while the mother is alive and appoint a US beneficiary.
Rallo
Posts: 4
Joined: Sun Nov 03, 2019 10:39 pm

Re: Distributing U.S. IRAs to U.S. and Canadian Beneficiaries

Post by Rallo »

This is an interesting thread which partially addresses my situation. My wife and I reside in the US ( US Citizens) but we are also Canadian citizens and have been in the US for the past 18 years. Our children and grandchildren live in Canada and are named beneficiaries on our accounts. I understand from previous posts above that they would have to pay both US and Canadian income taxes on the full amount of the inherited funds. Would that situation be any different if my wife and I moved back to Canada so that we are residents there. We would still keep the IRA account in the US and take normal distributions as usual. Thanks for your help and advice.
a18ion2
Posts: 3
Joined: Tue Apr 23, 2019 2:16 pm

Re: Distributing U.S. IRAs to U.S. and Canadian Beneficiaries

Post by a18ion2 »

Here's my take on it, E&OE:

Moving back to Canada with Traditional IRAs in hand won't do anything for your Canadian resident beneficiaries. They will have both US and Canadian taxes to pay on your death (but as noted before, will not be double taxed, they will get credit in Canada for the US taxes paid).

However, as also noted, were you to convert your Trad IRAs to Roth IRAs while you are US Residents, then they will be treated the same in Canada as in the USA in your hands (i.e. tax free) while you're alive in Canada, and also for your Canadian resident beneficiaries. That is, no income tax will be due on the Roth IRAs passing to your beneficiaries.

As also noted, US financial companies are leary of having "foreign" customers. [This issue is well covered if you google it.] So even US Citizens living abroad will find their US accounts closed or "frozen". For example, Fidelity says that if you move abroad, they can't close your IRA, but they will "freeze" it. That is, they won't let you add or make changes. The normal way around that is to keep your US brokerage account address in the USA by using a US mailbox service, or a relative. But be careful, some States (e.g. CA) will try to match 1099s addressed in CA with a CA taxpayer. And send a demand if you have an address in CA but no tax return. So use an address in NH, TX, FL or WA, etc. where there are no state income taxes. [I make no comment about whether using a US address while you live in Canada can lead to other problems; other people may have more experience with that.]

Lastly, your Canadian resident beneficiaries will not be able to keep a US Roth IRA (because, as above, the financial company won't take new Canadian residents as customers), but they can get the value paid to them income tax free.

No mention here is made of US estate tax. As US Citizens you'll have that, but only if you have over $20 million as a couple. Assuming that's not the case, then no worries on that front!
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