A Roth 401(k) Odyssey

Have I mentioned how proud I am to have helped the CRA clarify their Roth 401(k) guidance?

The Roth 401(k)’s older cousin, the Roth IRA, was well understood by Canadian tax planners.^[1]See e.g. Stuart L. Dollar, “Strategies for Canadians with U.S. retirement plans” (Sun Life Financial, June 2017). Folks who moved to Canada were (and still are) advised to file an election with the CRA to claim the benefit of Article XVIII paragraph 7 of the tax treaty,^[2]Convention Between the United States of America and Canada with Respect to Taxes on Income and on Capital, signed at Washington, DC on September 26, 1980, as amended by the Protocols signed on June … Continue reading which provides a deferral of Canadian tax on investment income inside the account.^[3]US-Canada treaty, Article XVIII(7) (providing that any tax which would otherwise attach to income at the time it is realized within the plan may instead be deferred “until such time as… a … Continue reading And when they’re ready to retire, any distributions that qualify as tax-free under US rules^[4]Subsection 408A(d) of the Internal Revenue Code of 1986, as amended (herein referred to as “IRC”), defines and excludes from income a “qualified distribution”, which is one that is taken … Continue reading are also free of Canadian tax under the treaty.^[5]US-Canada treaty, Article XVIII(1) (exempting a Canadian resident’s US pension payment from Canadian tax, to the extent that a US resident would exclude it from US tax—and vice versa). Together these two treaty provisions can often not just defer tax, but eliminate it.^[6]Tax is eliminated for qualified distributions. A nonqualified early distribution (before age 59½) is taxable, but only on the portion attributable to investment earnings. See Treas. Reg. § … Continue reading

The situation was less clear for a Roth 401(k). Practitioners gave varied answers to questions such as:

1. Do the treaty benefits described above also make themselves available to the Roth 401(k)? (Spoiler: yes.)
2. Is the XVIII(7) deferral election necessary for a Roth 401(k) to be treated favorably in Canada? (Spoiler: usually not!)

For many years, the CRA offered little to no guidance on these questions.^[7]The rules and treaty election procedure for a Roth IRA were published in Income Tax Technical News No. 43 (September 24, 2010). This document acknowledged in passing (p. 3) that a Roth 401(k) might … Continue reading Then, in October 2020, they unveiled Folio S5-F3-C1, Taxation of a Roth IRA.^[8]Herein referred to as the “Roth Folio”. This new Roth Folio was an opportunity for the CRA to dispel a fog around the Roth 401(k). But the first draft contained ambiguous cautionary statements which only reinforced, perhaps even exacerbated, the uncertainty.

I explained the problem to the CRA in a submission I prepared during the Roth Folio’s notice-and-comment period.^[9]Steve Kobes, “Comment re. Folio S5-F3-C1, Taxation of a Roth IRA” (Dec 29, 2020), available at <https://basis.kobes.ca/wp-content/uploads/2022/02/20201229-CRA-Comment.pdf>. In response to my feedback, the CRA revised the Roth Folio by adding paragraph 1.28, which essentially resolves the concerns I raised.

The result: for typical US 401(k) plans that include an employer match as well as a designated Roth account, we can now conclude with reasonable confidence that the XVIII(7) deferral election is superfluous, because the Income Tax Act^[10]RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as “ITA”). regards the entire 401(k) plan, including the Roth portion, as an employee benefit plan (EBP), which is not taxable to the participant until such time as the plan pays out a benefit (i.e., makes a distribution).^[11]ITA s. 248(1) defines “employee benefit plan”; s. 56(1)(a)(i) taxes a pension benefit received from an EBP if the employee was not resident in Canada when they performed the related work. See … Continue reading

And when a qualified distribution from a Roth 401(k) occurs, the treaty shields it from Canadian tax, just like a Roth IRA.^[12]US-Canada treaty, Article XVIII(1). That’s because both Roth IRA and Roth 401(k) are classified as “pensions” for purposes of Article XVIII.^[13]US-Canada treaty, Article XVIII(3)(b) (defining “pensions” to include “a Roth IRA…, or a plan or arrangement… that the competent authorities have agreed is similar thereto”); and … Continue reading The treaty provision that applies to distributions—unlike the provision for deferral—doesn’t require any special election.

Much of this was already well documented if you knew where to look. But the point of clarification I obtained with paragraph 1.28 of the Roth Folio is that a 401(k) plan is regarded holistically for EBP status, rather than looking at its Roth component in isolation.^[14]We caught a glimmer of this principle in CRA Document 2020-0846401E5 around the same time that the Roth Folio was published. Here the CRA does not mention the EBP, but they do say: “Since a Roth … Continue reading That matters because the definition of an EBP requires employer contributions.^[15]ITA s. 248(1) defn. “employee benefit plan” (“arrangement under which contributions are made by an employer” or a custodian for the employer). See also CRA Document 9624315 (a 401(k) plan … Continue reading If, as is typical, the employer match is a separate, pre-tax account inside the 401(k),^[16]It is now possible for an employer match to go into a Roth account, but this is a very recent development (IRC § 402A(a)(2), added by the Secure 2.0 Act of 2022). then the Roth account tested by itself would fail to qualify as an EBP. But since the 401(k) plan is tested as a single arrangement, it can be an EBP in its entirety, even if the plan segregates the employer match from the Roth contributions. Furthermore, it can be an EBP for all participants, even if only some of them receive employer contributions.

The obligatory warning label attached to Roth treaty benefits is that they don’t apply to any contributions that you make while residing in Canada.^[17]US-Canada treaty, Article XVIII(3)(b) (“pension” definitional carveout for non-rollover Roth contributions by a Canadian resident, and accretions subsequent to such contributions). See also Roth … Continue reading So once you move to Canada, you should stop contributing, and let your Roth account sit accumulating investment gains until you’re ready to withdraw. You’ll have to direct any new savings into Canadian plans, such as a Registered Retirement Savings Plan (RRSP) or a Tax Free Savings Account (TFSA).

All this is a wonderful deal for US employees who are thinking about retiring in Canada. Roth accounts are widely known in the US as a crucial tool for tax-efficient saving, especially for higher earners who (1) have too much income to deduct traditional IRA contributions^[18]IRC § 219(g) phases out the IRA deduction for people who are covered by an employer plan and have income above certain inflation-adjusted thresholds. See IRS Publication 590-A, Contributions to … Continue reading and (2) can utilize “mega backdoor” conversions of after-tax 401(k) contributions to route large annual amounts into the Roth umbrella.^[19]After-tax 401(k) contributions are constrained only by the limit on total annual additions under IRC § 415(c), which is $69,000 for 2024 (Notice 2023-75). If the plan tracks them as a “separate … Continue reading The treaty’s robust protections, explained above, make Roth accounts an attractive option for Canadians who may be living and working in the US while harboring thoughts of an eventual return to the Great White North.

The Roth 401(k) is close to my heart because it was challenge of grappling with these questions, during early stages of planning a move to Canada, that first sparked my enduring interest in international tax law. Quickly becoming disillusioned by the quality of the professional advice I received, I started down a path of self-research. Seeing the impact of my efforts in the CRA’s Roth Folio revision, four years later, is a gratifying capstone to a personal journey.