While many U.S. citizens living in Canada have recently become aware of the requirement to file annual U.S. individual income tax returns, they may not be aware of the specific filing requirements in regard to certain registered retirement plans held in Canada. Many of our Canadian clients that reside and work in the U.S. (similarly U.S. taxpayers working in Canada) are surprised by the complexity of reporting that is required to maintain compliance with the U.S. code. One such area that commonly causes surprise is with Canadian Registered Retirement Savings Plans (RRSPs).
The Registered Retirement Savings Plan (RRSP) program is fundamental to Canadian retirement planning, and most Canadian residents participate. RRSPs are a retirement savings program in which contributions are deducted from taxable income and any investment growth is deferred from taxation until the owner of the account makes withdrawals. This is very similar to the concept of U.S. retirement plans, such as IRAs.
These programs in the U.S. and Canada are excellent retirement strategies as they provide significant tax savings while allowing the retirement accounts to grow tax-free for eventual use during retirement when income and tax rates are expected to be lower.
RRSPs are not tax-deferred under the U.S. Internal Revenue Code, and thus the income generated inside these accounts technically is taxable income for U.S. tax purposes. It is only through an election in the Canada-U.S. Income Tax Treaty that these accounts may receive tax-deferred status in the U.S.
However, there is a complication for US citizens resident in Canada and likewise Canadian citizens resident in the US, who are subject to US tax rules. Many assume that because the growth in an RRSP account is sheltered from tax in Canada, it need not be reported and taxed in a US tax return either.
Unfortunately, this is not true and potentially a costly mistake. The default treatment of RRSP accounts under US tax law is that the income earned in the account (whether interest, dividends or gains) are reportable on the tax return and subject to taxation. In addition, there is no deduction for contributions to the RRSP account. This can cause U.S. tax compliance problems for U.S. taxpayers that don’t appropriately address and report these accounts on their U.S. tax return.
RRSP Election and Form 8891
To protect the retirement savings in your RRSP, you may invoke certain rights available in the Canada-U.S. Tax Treaty. Canadian RRSP accounts held by U.S. taxpayers require specific reporting with the IRS in order to receive tax-deferred status in the U.S.
The Canada- US Tax Treaty does provide some relief in this situation. Under Article XVIII(7), a US taxpayer may elect to defer tax on the growth within an RRSP account for US purposes.
To make the election pursuant to Article XVIII(7) of the Treaty, U.S citizens must file IRS Form 8891, U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans, for each year the account is held. A separate Form 8891 is required for each RRSP account. The form requires certain information regarding the accounts, including the account number and the balance held in the account at the end of the tax year. Form 8891 is to be filed annually with the U.S. individual income tax return.
If the U.S. citizen or resident elects deferral of taxation through the Canada/U.S. income tax treaty, they won’t have to file Form 3520 for contributions and Form 3520-A for ownership of an RRSP, which would normally be required by default IRS tax code treatment without the election. Failure to file these forms can result in penalties of 35% of all contributions to RRSPs and 5% of the balance in the RRSP.
Unfortunately, even with an election, the IRS will not permit a deduction for RRSP contributions. However, the bright spot is that even so, the generally higher tax rate applicable in Canada will provide some offset in the form of the foreign tax credit.
RRSP and FBAR Reporting
As the IRS ramps up its already aggressive search for unreported foreign accounts, many Americans are learning for the first time that their Canadian accounts must be reported to the IRS.
It is important to be aware that a disclosure exception for an RRSP account is not available for FBAR and Form 8938 reporting even with the Form 8891 election, like for IRA accounts. Taxpayers must disclose RRSP holdings on the FinCen Form 114 (FBAR) and Form 8938, when the filing requirements are met.
Failure to file either form carries significant penalties. Unfortunately, the FBAR penalties are severe; they can be as high as $100,000 per year or 50% of the highest value of the unreported account.
These extreme penalties scare away many taxpayers. Rather than come into compliance, they simply ignore the problem, hoping to avoid getting caught. Beginning July 1, 2014, however, foreign banks will be required to identify accounts owned or controlled by Americans. Hiding from the problem won’t work for long.
Late RRSP Election
Failure to file the annual election will result in the accounts becoming taxable in the U.S., and any income generated within an account must be reported as income on the U.S. individual income tax return, even if no funds are withdrawn from the account. This can lead to additional U.S. taxation and the loss of tax-free growth in the RRSP account.
Under new IRS streamlined filing compliance procedures, U.S. citizens residing in Canada who have failed to file these forms may use the procedures to become compliant, even if they have previously filed their U.S. individual income tax returns. Click to learn more about the new IRS streamlined filing compliance procedures.
The IRS has determined in the past that many people who have RRSPs are not reporting. For those not reporting, it’s not hard to hop on board as the increased disclosure is relatively painless with little to no tax impact.
So what should you do?
Contact Tax Samaritan, an experienced tax professional immediately. We can assist you with the process of preparing your tax return and Form 8891 election and even assist with the streamlined filing compliance procedure.
Need more information on unreported RRSPs or other offshore accounts?
Click the button below to request a Tax Preparation Quote today to get started with the preparation of your US tax return and Form 8891 election.
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Tax Samaritan is a team of Enrolled Agents with over 25 years of experience focusing on US tax preparation and representation. We maintain this tax blog where all articles are written by Enrolled Agents. Our main objective is to educate US taxpayers on their tax responsibilities and the selection of a tax professional. Our articles are also designed to help taxpayers looking to self prepare, providing specific tips and pitfalls to avoid.
When looking for a tax professional, choose carefully. We recommend that you hire a credentialed tax professional such as Tax Samaritan that is an Enrolled Agent (America’s Tax Experts). If you are a US taxpayer overseas, we further recommend that you seek a professional who is experienced in expat tax preparation, like Tax Samaritan (most tax professionals have limited to no experience with the unique tax issues of expat taxpayers).
Randall Brody is an enrolled agent, licensed by the US Department of the Treasury to represent taxpayers before the IRS for audits, collections and appeals. To attain the enrolled agent designation, candidates must demonstrate expertise in taxation, fulfill continuing education credits and adhere to a stringent code of ethics.
Every effort has been taken to provide the most accurate and honest analysis of the tax information provided in this blog. Please use your discretion before making any decisions based on the information provided. This blog is not intended to be a substitute for seeking professional tax advice based on your individual needs.