Spousal beneficiary
When a spouse inherits an IRA or 401(k), they can take over the account as an inherited account or transfer the account into their own IRA or 401(k) on a tax-deferred basis.
IRA and 401(k) accounts generally have required minimum distributions (RMDs) beginning at age 73. These are subject to US withholding tax for a Canadian resident, and Canada taxes the withdrawal with a credit for the US tax already withheld.
A US citizen living in Canada must report their worldwide income on both a Canadian and US tax return.
Non-spouse beneficiary
When a non-spouse beneficiary inherits, the account value is not subject to immediate tax. This differs from the taxation of an RRSP, DC pension, or other Canadian retirement accounts for non-spouse beneficiaries. These Canadian retirement accounts are generally fully taxable to the estate of the deceased.
Instead, taxes are payable on subsequent withdrawals from the inherited IRA or 401(k). This can provide an opportunity for tax deferral, as well as a potential decrease in the tax rate payable. A deceased Canadian taxpayer with a high income in the year of death may pay over 50% tax on their tax deferred retirement accounts. A non-spouse beneficiary with a low or moderate income may pay a significantly lower rate of tax.
There is a 10-year rule that allows withdrawals to be taken over up to 10 years following the account holder’s death. In the meantime, the account remains tax deferred in the US and Canada.
US withholding tax
Withholding tax on US retirement account distributions to non-residents is typically 30%; however, a Canadian beneficiary can submit Form W-8BEN – Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding to the financial institution. This will allow them to withhold the lower 15% rate.
This is important because Canada will only allow a foreign tax credit for the 15% treaty rate. If a higher rate is withheld, a beneficiary may need to file a US tax return to get a refund from the Internal Revenue Service.
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Inherited Roth IRAs
A Roth IRA is like a Canadian tax-free savings account (TFSA). A spouse beneficiary can take over the account or transfer it to their own Roth IRA.
Roth IRAs are generally tax-free in the US and can also have tax-free status in Canada; however, an account holder must file an election with the Canada Revenue Agency (CRA) to maintain the tax-free Canadian status and ensure no new contributions are made.
A non-spouse inheriting has the same CRA election requirement, but has a different tax-free status opportunity. There is a 10-year rule for non-spouse beneficiaries, allowing only a limited tax-free growth period.
Roth IRA withdrawals are tax-free in the US and Canada.
Exceptions
Disabled or chronically ill non-spouse beneficiaries may be exempt from the 10-year rule.
The 10-year clock does not start ticking for minor beneficiaries until they attain the age of majority.
Summary
IRA and 401(k) accounts work a little differently from Canadian RRSP, DC pension, and TFSA accounts on death. These US counterparts offer more favourable tax reduction opportunities.
If you expect to leave a US account as an inheritance, or you are inheriting one of these accounts, it is important to understand the rules. They may impact how you draw down your assets in retirement and how you structure your estate.
