Roth IRAs for Canadians
Should we look south for new retirement savings ideas?
by Jamie Golombek
Back in January, in the run-up to the federal election, the Conservatives announced that, if elected, they would introduce legislation to "eliminate the capital gains tax for individuals on the sale of assets when the proceeds are reinvested within six months". Almost a year later, the implementation of such a proposal still seems a distant dream.
While policymakers and pundit have suggested various forms that this measure could take, such as the C.D. Howe's proposal to introduce a new Capital Gains Deferral Account, perhaps all we need to do is to look to our neighbours to the South and their Roth individual retirement accounts (Roth IRAs).
What is a Roth IRA?
Roth IRAs were introduced in the U.S. in 1998. A Roth IRA is a U.S. retirement plan, similar in some respects to a Canadian RRSP, since earnings (income or gains) within the plan are not subject to annual taxation. The main difference, however, is that unlike RRSPs, contributions into a Roth IRA are not tax-deductible and withdrawals, including any earnings therein, are not subject to tax upon withdrawal.
In the U.S., Roth IRAs are poised to gain even more popularity as a result of newly enacted U.S. tax legislation, such as the Tax Increase Prevention and Reconciliation Act, which was passed in May, and the Pension Protection Act, enacted this past August. For example, the new U.S. rules will permit individuals who currently are precluded from contributing to Roth IRAs because their income is too high (a U.S. rule to limit access to low and middle income U.S. persons) to convert a traditional IRA into a Roth IRA, beginning in 2010.
Canadian taxation of Roth IRAs
Given the rising popularity of Roth IRAs in the U.S. and the influx of U.S. citizens into Canada in recent years, particularly in parts of the country like Alberta, you may very well have clients that are holding on to U.S. Roth IRAs. As discussed in a previous column (see "Rollovers of U.S. Retirement Plans to Canadian RRSPs" under the Tax & Estate Matters column in the October 2004 issue of FORUM), since it's not possible to convert a U.S. Roth IRA into a Canadian RRSP, many U.S. clients will continue to hold on to their Roth IRAs while living in Canada.
But how are they viewed from a Canadian tax point of view? A recent Canada Revenue Agency technical interpretation (2006-0186661M4) released just this past summer sheds some light on this topic.
For Canadian tax purposes, an ordinary IRA is generally considered to be a "foreign retirement arrangement" (FRA) under the Income Tax Act. Withdrawals from ordinary IRAs by Canadian residents are therefore subject to tax in Canada, except if the amount withdrawn would not, if the taxpayer were a U.S. resident, be subject to U.S. income tax.
A Roth IRA, however, does not meet the definition of an FRA under the Act and therefore is not subject to the above rule governing FRA withdrawals. As a result, withdrawals from Roth IRAs are generally not taxable in Canada either.
Since Canada doesn't recognize a Roth IRA as a tax-exempt plan, technically speaking, the annual earnings, be they income or gains, would normally be subject to annual Canadian taxation. How they're taxed, however, will depend on the type of Roth IRA (a trust, a custodial account or an annuity) and the rules governing Canadian taxation of these plans are extremely complex.
Luckily, Canadian residents who hang on to their Roth IRAs need not worry about annual taxation if they elect under paragraph 7 of Article XVIII of the Canada-U.S. tax treaty to defer Canadian taxation on any earnings in the plan but that are not distributed during the year. That being said, it is the CRA's opinion that if such an election is made, the earnings (but not the contributions) would ultimately be taxable in Canada when withdrawn from the Roth IRA.
Such an election should be made annually in the Canadian tax return by attaching a statement stating that the taxpayer is relying on Article XVIII(7) of the Treaty to defer annual taxation of Roth IRA earnings, and must include the following information:
plan name, account number, name of trustee and date of establishment;
capital contributions made to date, current balance of the plan;
the amount deferred in the current year; and
cumulative deferred earnings to date.
Finally, bear in mind that these rules are complex and in constant flux, so you would be well advised to have your client consult a cross-border tax expert on all matters of Canada-U.S. tax planning.