California residents who hold RRSPs, LIRAs, RRIFs or other Canadian tax-deferred accounts are subject to a unique set of tax and reporting requirements. Moreover, these requirements lead to higher tax preparation fees and complex recordkeeping for Canadians.
In this article, we discuss how to report Canadian tax deferred accounts on a California return and how proper financial planning and reporting from a qualified cross-border investment management firm – such as Cardinal Point Wealth Management – can mitigate the tax and complexities involved.
What are California’s Tax Rules?
Unlike most states, California does not allow Canadian retirement accounts to grow on a tax-deferred basis. And that can present a serious income-tax problem for residents of California, given the fact that the state taxes the annual income distributions (interest and dividends) and realized capital gains inside Canadian registered plans.
California rules require its tax residents to include annual investment earnings on their Form 540. Unlike the taxpayer’s U.S. federal return, the State of California (Franchise Tax Board) requires that you pay tax annually on your RRSP earnings.
You would be responsible for including your interest (line 8), dividends (line 9) and capital gains (line 12) of Schedule CA. They will ultimately appear in Column C for additions to income. If you have a capital loss, the loss would be reported in Column B of line 12.
It can be difficult to avoid including this income for California State tax purposes, given that the IRS shares a taxpayer’s complete tax return, including Form 8938, with the FTB. This gives the FTB the ability to determine whether a taxpayer has an RRSP and has included the accrued income within their tax return. To make matters worse, if a California resident were taking distributions from their RRSP/RRIF where Canadian withholding tax was being remitted to the Canada Revenue Agency (under the Treaty), this tax would not be eligible as a foreign tax credit for California State tax purposes. The state does not recognize, nor is it party to, the Canada—U.S. Income Tax Treaty.
What can be done to minimize tax?
Unfortunately and all too often, Canadian financial advisors overseeing Canadian retirement accounts are unfamiliar with California’s treatment of these accounts. What’s more, they do not offer investment strategies to ensure the management style and philosophy employed is uniquely mapped to California’s tax rules. And why would they? Their core clientele are Canadian residents with RRSPs, and not U.S. residents living in California. That is one of the reasons we suggest clients living in the United States, and especially California, work with a Canada-U.S. cross-border financial advisor.
As specialized Canada-U.S. cross-border financial advisors, Cardinal Point strives to reduce taxable transactions inside clients’ Canadian retirement accounts through a tax-managed style of investing. This is done by treating the account as if it were taxable (non-registered) rather than a traditional, tax-deferred retirement account. In doing so, the future tax consequences of each security selected are considered. For example, an RRSP account being managed on behalf of a Canadian resident might typically include higher-yielding, income-producing securities. This makes sense under Canadian tax rules for residents of Canada because investment income inside an RRSP plan is tax-sheltered. In California, however, the exact opposite is true. Therefore, it’s important to consider selecting investment securities that attempt to limit large taxable transactions or distributions inside the account.
Another key aspect of tax managing a Canadian retirement account is employing tax-loss selling when possible. When a security with a capital gain is sold, it’s important to proactively sell a security in the account with an unrealized capital loss to offset the gain where possible. If a security in the account has a large unrealized capital gain, we recommend clients work with their financial advisor to attempt to reduce the holding over a number of years to minimize taxes, versus selling out the entire position at once and incurring a hefty tax bill.
The ultimate goal is to tax manage the account to the greatest degree possible without compromising the integrity of the overall investment strategy or performance.
Other Considerations for RRSPs
Aside from tax managing Canadian retirement accounts on behalf of California residents, Cardinal Point also provides the following strategies:
- U.S. dollar-Denominated RRSPs: RRSPs can be managed in U.S. dollars, eliminating the need to monitor the Canada-U.S. exchange rate.
- Cross-Border Account Integration: integration with your U.S. investment accounts so that the investment strategies of your Canadian and U.S. accounts complement each other.
- Proper Tax Reporting: providing Canada-U.S. tax reporting and preparation services to ensure all IRS and state foreign account reporting and disclosures are done correctly.
- Discharging Your RRSP: advice on the best process, timing and tax strategy to distribute your RRSP.
California residents who hold Canadian tax-deferred accounts face a number of tax-planning and reporting challenges. In order to comply with California reporting requirements, and preserve as much of your capital as possible, we strongly advise that you work with a qualified cross-border financial advisor. Please don’t hesitate to contact the team at Gedeon Law & CPA if you are interested in learning more.