The Canada Revenue Agency says the TFSA is tax-free, but the IRS says it’s not. In the best-case scenario, if an American invests in a TFSA, and they have unused foreign tax credits on their U.S. return that year, they will pay nothing to the IRS.
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The commonly held belief that Americans can’t or shouldn’t use tax-free savings accounts (TFSAs) is misguided.
Taxes are never fun for the average Canadian, but they’re even less fun for those who are also U.S. citizens. That’s because the U.S. tax code is based on citizenship and not residency like almost every other country in the world.
So, people who are U.S. citizens, children of U.S. citizens, or in various other situations in which the U.S. deems a person to be a tax subject, then they have to contend with both the U.S. tax code and the tax code of wherever they live.
While Canada has a tax treaty with the U.S. that prevents double taxation, in most cases, there are countless areas the treaty doesn’t cover. One of the most notable is it doesn’t recognize the existence of TFSAs as the treaty predates the creation of these accounts.
The result is that the Internal Revenue Service (IRS) doesn’t recognize TFSAs as tax-free.
As such, advisors have recommended Americans living in Canada to stay away from this account type since they were first created in 2009.
While this was the correct answer when they launched and the limit was $5,000 a year, conventional wisdom no longer applies given the current lifetime limit of $81,500.
Before we determine if a TFSA makes sense for the traditional American in Canada, we need to understand what happens when an American owns a TFSA from both a tax and tax-filing requirements perspective.
First, it’s important to note that Americans living in Canada are subject to only U.S. federal tax rates and not state tax rates. These tax rates are lower than combined Canadian federal and provincial integrated tax rates.
For example, the top U.S. federal rate is 37 per cent and starts at $523,600 for a single person, versus the top rate in Ontario of 53.53 per cent on amounts of more than $221,708.
And no, they don’t pay twice. Thanks to the tax treaty, taxes paid in Canada offset taxes paid in the U.S. Therefore, despite the need to file in both countries, in general, most Americans living in Canada don’t pay a penny to the IRS annually, with a few exceptions.
Also, in most cases, all of the tax credit earned from paying taxes in Canada is not fully used up annually, meaning that additional income could have been earned in Canada without taxation.
How does this impact the use of the TFSA?
The Canada Revenue Agency says the TFSA is tax-free, but the IRS says it’s not. In the best-case scenario, if an American invests in a TFSA, and they have unused foreign tax credits on their U.S. return that year, they will pay nothing to the IRS.
In a worst-case scenario, they will pay U.S. federal tax rates. But as these rates are lower than the Canadian federal and provincial rates combined, this represents a form of tax arbitrage whereby funds that would have otherwise been invested in a taxable account and subject to Canadian tax rates are now subject to lower U.S. tax rates.
How costs factor into investment returns
So, given the tax advantage, why haven’t more Americans living in Canada been doing this from the beginning? The reason is the additional tax-filing costs.
The IRS requires that TFSAs must be reported as a foreign trust on IRS Forms 3520 and 3520-A. The cost of this filing varies among accountants but is roughly about $300. Also, additional costs could be required if mutual funds and exchange-traded funds (ETFs) are used as they would fall under the Passive Foreign Investment Company reporting rules and require additional disclosures including the file of IRS Form 8621 or a substitute statement.
While $300 may not seem like much, does it make sense to pay that cost on a $5,000 TFSA? That amounts to a 6 per cent filing fee, so the answer is no.
Does it make sense to pay $300 on a TFSA with a total contribution of $81,500? That works out to 0.37 per cent of the account, and shrinking every year. Assuming a 5 per cent rate of return, that equals 7.4 per cent of the pre-tax return. The question then becomes whether there is at least a 7.4 per cent differential in taxes between Canadian and U.S. tax rates to justify this cost relative to the worst-case scenario, when a client pays tax on the full return in the U.S. The answer, in general, is yes.
There are additional nuances around the taxation of dividend income from Canadian mutual funds and ETFs in the U.S. However, overall, the sweeping generalization that Americans shouldn’t open TFSAs is wrong.
Should they open one at any amount? No. As always, that depends on their personal situations, including their current tax situation, the cost of filing, and their expected rate of return.
Jason Pereira is a partner and senior financial consultant at Woodgate Financial Inc., a financial planning firm under the IPC Securities Corp. umbrella in Toronto, and president of the Financial Planning Association of Canada.
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