The Drawbacks of TFSAs and RESPs to US Citizens

For Canadian residents who are US citizens, the Canadian benefits from TFSAs and RESPs may be more than offset by increased US tax-compliance fees and possibly US tax liabilities. The best strategy may be to avoid these plans or, in the case of an RESP, to have the contributor be a non-US citizen (perhaps the spouse).

RESPs and TFSAs are not tax-deferred for US purposes. TFSAs have no special status under the Internal Revenue Code, and the IRS has not issued any direct guidance on their tax treatment. The accounts are generally offered as deposits, annuity contracts, or trust-type arrangements. All of these types of vehicles create US reporting requirements and taxable income to US investors. The IRS may consider TFSAs offered in trust-type arrangements to be foreign grantor trusts. Thus, if the RESP or TFSA contributor (grantor) is a US citizen, all interest, dividends, and capital gains on the amount invested must be reported annually for US tax purposes. In addition, the government grants associated with RESPs are considered income to the grantor. This income may generate US tax liability unless the contributor is paying Canadian tax on other passive investments and is able to use the associated US foreign tax credits to offset the liability on the grantor trust income.

The larger issue, however, is the additional US compliance burden. Typically, there will be a requirement to file, for each TFSA or RESP held by the US citizen, form 3520 ("Annual Return To Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts") for any year in which there is a contribution or withdrawal from the plan, and form 3520-A ("Annual Information Return of Foreign Trust with a U.S. Owner") for every year that the plan is in existence. The reporting becomes more complex if mutual funds are owned within the TFSA or RESP. If the taxpayer employs a tax practitioner for tax-filing purposes, the requirement to file these non-trivial forms will increase the professional fees. Given the relatively small amounts invested in most TFSAs and RESPs, these costs may approach or exceed the amount of Canadian taxes saved. There is a significant penalty exposure if the required forms are not filed on a timely basis.

For example, suppose that Jane Doe has invested $5,000 in her TFSA for 2012, her first year of contributions, and she has no other passive income. If she earns interest at 5 percent and if she has a Canadian marginal income tax rate of 50 percent, she will save $125 of Canadian tax. On the other hand, if she has a US marginal income tax rate of 35 percent, the Canadian tax saving will be mostly offset by US taxes of $88. More importantly, suppose that her cost of US filing increases by $1,150 ($500 per form plus 15 percent GST/HST [used for illustrative purposes only]). If so, investing in the TFSA will have cost Jane $1,238 instead of saving her $125.

Some practitioners may take the approach that RESPs and TFSAs should not be considered grantor trusts; however, senior officials of the IRS have indicated that from the IRS's viewpoint there is no change in approach with respect to the proper treatment of these types of plans.

Dawn Haley
PricewaterhouseCoopers LLP, Halifax
[email protected]

Canadian Tax Focus
Volume 3, Number 1, February 2013
©2013, Canadian Tax Foundation