In Canada, the Tax Free Savings Account (TFSA) allows qualified individuals to be able to earn income on a tax-free basis. In particular, the initial amount contributed as well as income earned in the plan is tax free, even when it is withdrawn.
While this may be appealing to Canadians living in Canada, anyone who is subject to the tax by Uncle Sam should think twice about holding and/or contributing to a TFSA account.
First, unlike a RRSP, a TFSA is not granted tax-deferred status by the IRS. As such, U.S. taxpayers are taxable on any income earned in a TFSA. This taxable status eliminates the TFSA benefits for most Canadian resident U.S. taxpayers.
Second, you may be required to report the TFSA to the US Department of the Treasury each year on the Report of Foreign Bank and Financial Accounts Form TD F 90-22. Failure to disclose the account can result in significant penalties.
Third, there is confusion on whether or not the IRS considers the TFSA to be a foreign trust. So far, the IRS has not taken an official position on this subject. If the IRS considers a TFSA to be foreign trust, then a U.S. taxpayer is an owner of a non-resident trust. As a result, Form 3520-A, “Annual Information Return of Foreign Trust With a U.S. Owner”, is required to be filed 2 ½ months after the trust’s year end. Failure to file a Form 3520-A with the IRS subjects you to a penalty equal to the greater of $10,000 (US) or 5% of the gross value of the TFSA at the close of that tax year.
Lastly, Form 3520, “Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts” may be required to report contributions and withdrawals from the TFSA. Failure to file this form may result in a penalty equal to 35% of the amount of the contribution or of the withdrawal.
With these factors in mind, we typically advise U.S. taxpayers, even those living in Canada, to avoid contributing to a TFSA and to consider withdrawing their TFSA funds(the withdrawal will not be taxable in Canada or the U.S.).
