401(K) Plans for Canadian Residents

More and more Canadians are working remotely for companies based in the United States, and are finding that participation in their employer's 401(K) plan might not be in their best interests, at least from a tax perspective.

Most of us are aware of the benefits of 401(K) savings programs, but if you are a Canadian resident, there are certain negative aspects you should know about. You need to weigh the pros and cons to decide if you should be involved in a 401(K). You might prefer to put your money into another type of retirement vehicle, like a Canadian RRSP.

401(K) plans can have some very tangible benefits, such as:

• Convenience–it's easier to save for retirement when contributions are deducted from pay at source;
• Employer contributions to the plan equal free money–usually a good thing;
• Professional investment management and administration;
• Deferment of U.S. tax on contributions; and
• Ability to contribute more to a 401(K) than to an IRA.

401(K) problems for residents of Canada can include:

• Exposure to currency fluctuations; and
• Double taxation of contributed amounts.

Currency Fluctuations

An employee of a U.S. company living in Canada, who plans to stay in Canada for retirement, runs the risk that the value of their U.S. 401(K) will decline due to currency exchange rates. For example, between 2001 and 2006 the average annual exchange rate between Canada and the United States plummeted from 1.5703 to 1.1341, a difference of roughly 28%. If you had $10,000 USD in a 401(K) plan in 2001 it was worth $15,703 CDN. In 2006, it was worth only $11,341 CDN.

Of course the U.S. dollar could strengthen and you could recover losses or make gains, but it is impossible to predict the future. Anyone who thinks they know in advance which way the rates are going to go is probably delusional (If not, I'd really like to meet them!). Do you want to expose your retirement savings to this uncertainty?

Potential for Double Taxation

Canada Revenue Agency will not recognize your investment in a 401(K) to be tax deferred, and you might pay tax on it twice. Even though you receive a tax break south of the border when you contribute, in the year of the contribution you still pay tax to Canada on the full amount of your income. Then, when you eventually retire, you pay tax to Canada or the United States yet again on the retirement income.

There are techniques that can make this problem go away. For example, if you remit enough federal, state, social security, and medicare taxes to the U.S. during the year, your Canadian foreign tax credit claim might kill off the excess Canadian tax. This maneuver doesn't quite work for everybody though–I've seen it go both ways.

Strategies to Ponder

Please consult a qualified tax advisor before taking any of these steps. You don't want to receive any nasty surprises! Your advisor should do a full mock-up of your Canadian and U.S. income tax returns before you make any moves.

If currency fluctuations bother you, consider a transfer of your 401(K) balance to Canada. A straight withdrawal from the 401(K) can have extremely negative tax consequences (read: the loss of a major portion of your retirement assets), but it can work out in some cases. It is also at least theoretically possible to transfer first from the 401(K) to an IRA, then from the IRA to an RRSP, with little loss of funds along the way.

Opting out of the 401(K) plan is a possibility. You could take the part of your income that would normally be contributed to a 401(K) and sock it away in an RRSP instead.

Finally, if you are a U.S. citizen, green card holder or resident alien, and you meet the Foreign Earned Income Exclusion requirements, some or all of your income could be considered to be foreign income for the purposes of the Foreign Earned Income Exclusion (even if it comes from a U.S. employer). If it is, you could exclude it entirely from U.S. taxation by filing Form 2555.