The true withholding tax for U.S. retirement accounts

Cross-border taxes are never easy to understand, as doing so requires learning not just two tax regimes, but also how they interact.

This is abundantly apparent when it comes to transferring U.S. retirement accounts to Canada.

Last month, we published a story on how to move 401(k) and IRA accounts from the U.S. to Canada.

We reported that thanks to the U.S.-Canada tax treaty, lump-sum withdrawals from U.S. retirement accounts are subject to a 15% withholding tax, as long as the client files Form W8-BEN with the plan administrator. Otherwise, withdrawals by non-resident aliens would be subject to 30% withholding.

That language was too strong. I should have stated that lump-sum withdrawals may qualify for the 15% withholding tax. The reason? The treaty allows a plan administrator to withhold 15% instead of 30% for what’s known as “periodic payments.” Periodic payments are not defined in the treaty, so it’s unclear whether lump sums are, in fact, periodic payments. It’s ultimately up to the plan administrator whether to withhold 15% or 30%.

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Due to this ambiguity, there is a “commonly held” view that not only periodic IRA distributions, but also lump-sum IRA withdrawals, could qualify for the 15% treaty rate, says Matt Altro, president and CEO of MCA Cross Border Advisors.

Indeed, this view has appeared in multiple articles from noted sources (including Advisor.ca).

But some who held that view are now changing it.

Stuart Dollar, director of tax and estate planning at Sun Life Financial, authored a comprehensive 2015 whitepaper on transferring U.S. retirement accounts. In it, he states that lump sums do in fact qualify for the 15% withholding. But today, he’d give different advice.

“The position referenced in the paper arose from discussions had with our U.S. tax reviewers,” he tells Advisor.ca in an email. “At the time, there appeared to be some ambiguity […] over what the correct withholding tax rate was: 15% or 30%. Some institutions were withholding only 15%, others 30%. The IRS appears to be clarifying its position that the withholding tax rate is 30%, and more financial institutions are imposing that rate. [A] revised paper will include those changes.”

We asked the IRS for comment, but did not receive a response before press time.

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“Since the IRA/401(k) custodian will be liable if it withholds at the lower rate [15%] than the tax owed [30%], it nearly always withholds at 30%,” says Roy Berg, director of U.S. Tax Law at Moodys Gartner Tax Law, who wrote me with his concerns about our piece. “If the taxpayer is eligible for the lower rate, [he or she] may file for a refund of the excess withholding.”

Berg adds that, due to widespread confusion over the proper rate, he often has to tell clients they do not qualify for 15% withholding.

What it all means

If your client is moving her U.S. retirement account to Canada, and needs or wants to make a lump-sum withdrawal, it’s best to be conservative.

“It is safer to assume that for lump-sum withdrawals, the 30% default IRS rate will apply,” says Altro. “However, it certainly doesn’t hurt to fill out [Form] W8-BEN and try to convince the [administrator] to honour the 15% treaty rate.” Again, the percentage withheld is ultimately up to the plan administrator, but as Altro says, “Try for the best (15%) and plan for the worst (30%).”

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He also suggests keeping this issue in perspective. “The question of whether 15% or 30% applies on lump sum withdrawals actually wouldn’t have any real impact for the vast majority of people,” he says. “We’re talking about IRS withholding for non-U.S. person Canadians, so the entire amount of the withdrawal would be taxable in Canada in any case, and the Canadian tax rate on the income would, in virtually all cases, be above 30%.”

But it’s still important for advisors to properly set expectations with clients about what’s being withheld.

“Greater withholding means less net cash upfront from the withdrawal,” adds Altro, “so the issue is still relevant.”

Getting technical

Roy Berg, director, U.S. Tax Law at Moodys Gartner Tax Law, explains that “Article XVIII(2)(b) of the Treaty reduces the U.S. tax on distributions from 30% to 15% only for periodic payments and not lump-sum payments.” He argues that some practitioners “have erroneously relied on regulation section 1.441-2 to support the position that the lump-sum payments are treated the same as periodic payments under U.S. law. The correct analysis starts with IRC 3405(d)(2) and 72 for the definition of periodic payment, which requires ‘payments at regular intervals for a period of more than one year.’ This position was confirmed in Private Letter Ruling 9537028.”

But to get more technical, Matt Altro, president and CEO of MCA Cross Border Advisors, says that Private Letter Rulings “can’t be relied upon as precedent for other parties who are not party to the ruling.”

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.