Should a US Person living in Canada have a TFSA?
Written by Carson Hamill CIM®, CRPC®, Associate Portfolio Manager and Assistant Branch Manager, and Dean Moro BComm, CIM®, Financial Advisor and Associate Portfolio Manager
Many U.S. citizens residing in Canada face a unique financial challenge with the Tax-Free Savings Account (TFSA). Despite being Canadian residents, U.S. citizenship complicates the ability to benefit from the TFSA's tax advantages due to conflicting tax regulations between the two countries. This blog explores the complexities U.S. individuals encounter and provides guidance on navigating the implications of holding a TFSA as a U.S. person.
* This blog is focussed on the cross-border complexities associated with TFSAs. For more general information about TFSA accounts, click here.
A Common Cross-Border TFSA Scenario:
Jim is a U.S. person living in Canada. Although he was born in the United States, he has spent the majority of his life in Canada after his family moved to the beautiful north when he was young. His current financial advisor has set him up with a Tax-Free Savings Account (TFSA), not understanding the repercussions of a TFSA for U.S. individuals.
To Jim’s surprise, he faces a unique challenge. As a U.S. person, he can't benefit from these accounts in the way regular Canadians do. The U.S. tax system will not recognize the tax advantages of the TFSA, resulting in complex tax reporting and the risk of double taxation. These accounts are specifically designed for Canadian residents, making Jim’s situation complicated.
The question then becomes – what should Jim do?
Tax-Free Savings Account (TFSA) and the Canada-U.S. Tax Treaty
The Canada-U.S. Tax Treaty seeks to prevent double taxation for individuals residing in either country. However, it's important to note that the TFSA is not classified as a pension under this treaty. This means that while interest, dividends, and capital gains within a TFSA are tax-free in Canada, they may not receive the same treatment in the U.S., particularly for U.S. citizens or residents who hold TFSAs. For U.S. citizens or residents residing in Canada, any income earned within a TFSA could potentially be subject to U.S. taxation, thereby reducing the benefits of the TFSA account. Therefore, it's crucial to carefully consider these implications before investing in a Tax-Free Savings Account (TFSA) if you are a U.S. individual or have cross-border tax obligations similar to Jim.
It is vitally important to seek advice from a cross-border tax professional who can provide clarity and guidance on the most suitable savings or investment strategies tailored to the U.S. individual’s specific circumstances.
TFSA Rules for Non-Residents of Canada
For non-residents of Canada, the prospect of holding a Tax-Free Savings Account (TFSA) is technically feasible. Contributions can still be made, albeit navigating the rules can be daunting.
If you become a non-resident and continue to contribute to your TFSA, you will incur a 1% tax penalty for each month the contribution remains in the account. This measure discourages non-residents from leveraging tax advantages while no longer residing in Canada.
Seeking advice from a tax professional is highly recommended for non-residents. This guidance is essential for understanding individual circumstances and avoiding potential penalties. It ensures clarity and peace of mind in managing your financial affairs across borders.
U.S. Tax Implications of Canadian TFSAs: Essential Considerations
- Earnings from your Canadian Tax-Free Savings Account (TFSA) are subject to U.S. income tax. You must report these earnings as taxable income on your U.S. tax return. A foreign tax credit can not be claimed.
- Special filing requirements apply if your TFSA invests in a Passive Foreign Investment Company (PFIC), such as Canadian mutual funds or ETFs. In such cases, you may need to file additional forms to comply with U.S. tax laws.
- The types and amounts of investments held within your TFSA dictate additional filing obligations. Since a TFSA is considered a foreign financial account, you must adhere to FBAR (Report of Foreign Bank and Financial Accounts) and FATCA (Foreign Account Tax Compliance Act) regulations. These reports must be submitted to the IRS and Financial Crimes Enforcement Network (FinCEN).
Navigating these requirements can be complex and burdensome, requiring meticulous attention to detail, along with additional accounting expenses.
Consequences of Liquidating a TFSA
Considering the complexities involved in holding a TFSA as a U.S. person residing in Canada, the decision to liquidate a TFSA requires careful consideration of both U.S. and Canadian tax implications.
U.S. Perspective:
Liquidating the TFSA triggers a taxable event for U.S. tax purposes. Any accrued gains within the account, whether short-term or long-term capital gains (held for more than one year), would be subject to U.S. taxes. If Jim holds Passive Foreign Investment Companies (PFICs) in his TFSA, the tax treatment of those gains may differ. Depending on Jim's overall income level, investment income, and filing status, he might also be liable for an additional Net Investment Income Tax (NIIT) of 3.8% on the gains.
Canadian Perspective:
From a Canadian tax standpoint, liquidating a TFSA does not incur any income tax consequences. The fair market value (FMV) of the TFSA at the time of liquidation will be added to Jim's accumulated TFSA contribution room in the following calendar year.
It's important to note that Jim may potentially offset some of the U.S. federal tax liability with a foreign tax credit based on Canadian taxes paid on taxable passive income held outside of a registered Canadian account (dividends, gains, and interest). However, the exact impact on Jim's taxes will depend on the value and gains within the TFSA, as well as his tax filings in both Canada and the U.S. in previous years.
Navigating these considerations requires a thorough understanding of Jim's financial situation and consultation with tax professionals proficient in cross-border taxation to provide precise advice tailored to his particular circumstances.
Investing in a TFSA as a U.S. Individual
When it comes to holding a TFSA as a U.S. individual, there are many factors to consider. If choosing to maintain a TFSA as a U.S. individual, the best investments to consider would be growth-focused securities with little to no dividends, and PFIC investments should be avoided.
We strongly advise consulting with a cross-border professional for these matters.
Summary
Many U.S. persons living in Canada discover that a TFSA poses significant tax challenges under U.S. law. While TFSAs offer tax-free growth in Canada, they are not recognized as tax-exempt accounts by the IRS. This discrepancy means a U.S. person may face U.S. taxation on earnings within their TFSA, potentially leading to double taxation and complex reporting obligations. Moreover, liquidating the TFSA could trigger taxable events in the U.S., depending on the investments held. To manage these complexities, U.S. individuals must seek advice from cross-border tax professionals who can provide tailored strategies for their unique situation, ensuring compliance with both Canadian and U.S. tax laws.
Next Steps
If you’re planning on moving to Canada and need assistance with your investments, estate planning, and portfolio management, please contact Snowbirds Wealth Management as we specialize in cross-border financial planning and wealth management. We work closely with experienced cross-border lawyers and accountants to ensure you have a team behind you.
About Snowbirds Wealth Management
Gerry Scott is a portfolio manager and founder of Snowbirds Wealth Management, an advisory firm focussed on the cross-border market. Together with Dean Moro and Carson Hamill, associate portfolio managers with Snowbirds Wealth Management, they provide investment solutions for Americans living in Canada, and Canadians residing in the United States. Licensed in both Canada and the U.S., they provide tailored investment solutions to minimize the tax burden when moving assets across borders.
To schedule an introductory call, please click here.
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