Inheriting U.S. individual retirement accounts

Given our proximity to the United States, many Canadians have financial dealings on both sides of the border. This means some clients may be the beneficiaries on an individual retirement account (IRA).

While an IRA is the U.S. equivalent of an RRSP, the tax treatment at death can trip up many Canadian-resident beneficiaries.

U.S. taxation of IRAs at death

IRAs and RRSPs are similar but not identical. One difference is who is taxed on the proceeds at death. In the U.S., when an IRA holder dies, the named beneficiary — not the deceased — is taxed on the lump sum amount received. In Canada, the RRSP holder is taxed at death unless the beneficiary named is a qualifying survivor (spouse/common-law partner or a financially dependent child or grandchild). A qualifying survivor can defer tax on the amount received by, for example, transferring it to their RRSP or purchasing an annuity. The tax deferral options differ by qualifying survivor.

The Canada-U.S. tax treaty establishes how each country taxes their residents on income received from the other country. Generally speaking, when U.S. income would otherwise be taxable to a U.S. taxpayer, it’s taxable in Canada when received by a Canadian resident. So Canadian residents who receive amounts as an IRA beneficiary must report this as taxable income on their Canadian tax return and pay tax in Canada. If there is any non-resident withholding tax on the IRA payment (which could be up to 30% on lump sum payments), it can be used as a tax credit to reduce Canadian tax. (The early withdrawal tax of 10% that would normally apply to IRA withdrawals prior to age 59-and-a-half doesn’t apply on withdrawals due to the IRA account holder’s death.)

While there may be U.S. tax-deferral options available for U.S.-resident beneficiaries, these options may not be available to Canadian residents. This would need to be confirmed directly with the U.S. financial institution. One option that could be available to Canadian residents is to receive a lump-sum payment from the deceased’s IRA.

IRA beneficiaries fall into one of two categories: non-spouses and spouses (including common-law partners). While the Canadian tax treatment of the lump-sum withdrawal is the same for both, the option for deferring Canadian tax is different.

Non-spouse beneficiary

When an IRA beneficiary is not the spouse of the deceased, the amount received as a lump sum is fully taxable in Canada. It may also be subject to non-resident withholding tax at source in the U.S.

What if the beneficiary wants to reduce the Canadian tax owing on the amount received from the IRA? The answer is simple: contribute an amount up to the pre-tax IRA lump sum payment in Canadian dollars to their RRSP. The contribution must be made no later than 60 days after the end of the calendar year in which the IRA amount was received (the same timing as with a normal RRSP contribution). Since this would be considered a new contribution, the beneficiary needs to have enough RRSP contribution room available.

Spouse beneficiary

Like a non-spouse beneficiary, a spouse can deposit the lump-sum received from an inherited IRA to an RRSP (not a spousal RRSP or RRIF) to defer tax. Again, non-resident withholding tax may apply at source in the U.S. However, unlike a non-spouse beneficiary, this can be done as a transfer and doesn’t require RRSP contribution room.

This is possible because the Income Tax Act allows for U.S. IRAs to be transferred to RRSPs. Generally, this transfer option is considered when the IRA holder is alive. However, it can also be used by a surviving spouse to transfer a lump sum from their deceased spouse’s IRA to their own RRSP. This effectively makes the tax treatment of the inherited IRA the same as when a surviving spouse transfers the amount received from the deceased spouse’s RRSP to their own. To qualify, the following conditions must be met:

1. The amount received from the IRA is included on the recipient spouse’s Canadian tax return as taxable income.
2. The amount received was funded by contributions made to the IRA by either the recipient or the recipient’s spouse. This is known as an eligible amount.

To complete the transfer, the RRSP deposit must be made no later than 60 days after the end of the calendar year during which the lump sum IRA payment is received.

The basic steps for the transfer are:

1. Request and receive a lump-sum payment from the deceased’s IRA.
2. Deposit the amount, converted to Canadian dollars, into an RRSP no later than 60 days after the end of the year the payment was received. This is different from transfers between RRSPs, which must be done directly between the accounts.
3. Report the IRA income on the recipient’s Canadian tax return.
4. Spouse beneficiaries would report the RRSP deposit as a transfer on Schedule 7. Non-spouse beneficiaries would report the RRSP deposit as a new contribution on Schedule 7.

These steps allow the RRSP deposit to be deducted from the lump-sum payment that was reported as income. If the two amounts are equal, there is no Canadian tax. Any withholding tax paid in the U.S. can be used as a tax credit to reduce Canadian tax paid in that same year via the foreign tax credit. Unfortunately, if the foreign tax credit isn’t fully utilized, the unused amount can’t be carried forward or back and is lost.

Finally, the RRSP deposit doesn’t impact the spouse beneficiary’s RRSP contribution limit.

Many Canadian-resident beneficiaries of IRAs are surprised to learn that the amount they received is taxable to them. The good news is there’s a simple way to reduce or eliminate tax — their RRSP. Whether the RRSP deposit is a transfer (spouse beneficiary) or a new contribution (non-spouse beneficiary), the result is the same — Canadian tax is deferred.

Curtis Davis

Tax & Estate

Curtis Davis, FCSI, CFP, TEP, is director for tax, retirement and estate planning services, retail markets at Manulife Investment Management.