Comparing Canadian & American Retirement Plans – Part 1
A Guide for Navigating the Cross Border Jungle of Retirement Accounts.
Not unlike trying to a cut a path through a dense and tangled jungle, navigating the terrain of cross border planning can be tricky. With pitfalls to avoid, and rules to untangle, even the most intrepid self-guided investor can be left feeling a bit lost and confused. Creating a cross border retirement plan involves sifting through a variety of options, avoiding tax traps, and navigating the rules of two countries all while trying to maximize the financial potential of your retirement accounts.
In this two-part blog series, I offer guidance to help untangle the complexities of the US and Canadian pre-tax retirement accounts (made with pre-tax contributions) and after-tax retirement accounts (made with after-tax contributions).
In this first entry, I compare and contrast the most common pre-tax retirement accounts in Canada and the US and offer some thoughts on the cross border utilization of pre-tax retirement accounts.
The second entry in this retirement planning series will focus on after-tax retirement accounts (i.e., TFSAs, Roth IRAs, and Roth 401(k)s).
For now, let’s turn our attention to navigating pre-tax retirement accounts.
Pre-Tax Retirement Accounts: The Similarities
RRSP and Traditional IRA
In Canada, the most common pre-tax retirement account is the Registered Retirement Savings Plan (RRSP), which was created by the government in 1957 to encourage Canadians to save for retirement. The American version of the RRSP is the traditional Individual Retirement Account (IRA), which was created in 1974 with a similar retirement savings mandate.
Both governments included two sweeteners to encourage people to use these retirement plans: i) they made contributions tax-deductible, which provides people with immediate tax savings; and ii) they allowed contributions and growth in these retirement plans to grow tax-free until they are withdrawn.
Group RRSP and 401(k)
The group RRSP has similar features to an individual RRSP. The difference is that the group RRSP is employer-sponsored whereas just about anyone who has earned income can hold their own individual RRSP. The American equivalent is the 401(k), which is the employer-sponsored version of the traditional IRA.
One of the main benefits of both the group RRSP and the 401(k) is that employers will often provide the additional benefit of employer matching (i.e., free retirement money). For instance, if you contribute 3% of your salary to your group retirement plan, and your employer matches up to 3%, the total contribution to your retirement plan would be 6%.
Pre-Tax Retirement Accounts: The Differences
Although the Canadian and American pre-tax retirement accounts have similarities, there are three main differences between them.
Annual Contribution Limits
The biggest difference between Canadian and American pre-tax retirement accounts is the amount you can contribute annually. On the Canadian side, the annual contribution room is generous. For RRSPs, the annual contribution limit is 18% of your last year’s earned income, up to a maximum of $29,210 in 2022. However, this is not the case on the American side. For traditional IRAs, the annual contribution limit in 2022 is s $6,000 for people under the age of 50 and $7,000 for people over 50. The 401(k) helps even the playing field a bit by allowing an additional annual contribution limit of $20,500 in 2022. For individuals over the age of 50, there is an additional catch-up contribution of $6,500 allowed in 2022.
The maximum contribution limits of the traditional IRA and 401(k) are treated separately, while the RRSP and group RRSP share the same maximum contribution limit. However, there is a wrinkle in the contribution limits for the traditional IRAs and 401(k)s, where the maximum contribution limit has to be shared with the after-tax retirement accounts (e.g. Roth IRAs and Roth 401(k)s). For instance, the traditional IRA has to share the same maximum contribution limit with the Roth IRA, and the 401(k) has to share the same maximum contribution limit with the Roth 401(k). That said, it may be the case that if you have a 401(k) or other qualified retirement plan, your traditional IRA contribution may not be tax deductible.
Another significant difference between Canadian and US retirements plans is whether or not you can carry forward unused contribution room to the next year. In both the group RRSP and the individual RRSP, any unused room carries forward to the next year. This carry forward option does not expire, meaning you can accumulate room from all the previous years you earned room. However, for the US, this carry-forward option is not available for the traditional IRA and 401(k). Therefore, if you do not contribute the maximum to your traditional IRA or 401(k) on an annual basis, this chance is lost.
Lastly, withdrawal policies and their resulting tax consequences differ greatly between different types of retirement accounts.
For RRSPs, early withdrawals (before age 71) result in the following withholding taxes (WHT): 10% on withdrawals up to $5,000, 20% for withdrawals between $5,000 and $15,000, and 30% for withdrawals over $15,000. In Quebec, WHT are higher at 20% on withdrawals up to $5,000, 25% for withdrawals between $5,000 and $15,000, and 30% for withdrawals over $15,000.
On the other hand, early withdrawals (before age 59½) from a traditional IRA or 401(k) will result in a 10% penalty tax. In addition, early withdrawals will also be subject to ordinary income taxes. Unlike the WHT for RRSPs, the penalty tax is non-refundable and cannot be claimed back on a tax return.
Luckily, both these additional taxes (WHT and penalty tax) are discontinued as you withdraw in retirement or start the required minimum withdrawals from each retirement account.
The required minimum withdrawal in RRSPs is called the Registered Retirement Income Fund (RRIF) minimum withdrawal, which starts at age 72. RRSPs are automatically rolled over to RRIFs when a person turns 71 and the RRIF minimum withdrawal starts in the year after the conversion to a RRIF.
In both the traditional IRA and 401(k), the required minimum withdrawal is called the Required Minimum Distribution (RMD), which starts after age 72. An exception to starting the RMD after age 72 in the 401(k) occurs if you are working for a current employer past this age.
Both RRIF minimum withdrawals and RMDs are subject to income taxes as well. This is because the government remembers that you have not yet paid tax on your original contributions and the growth in your pre-tax retirement plans. As a result, these withdrawals are treated as regular income. The upside is that in retirement, most people find themselves in a lower tax bracket.
Table 1: RRSP & Group RRSP vs Traditional IRA & 401(k)
|Annual Contribution Limits||18% of earned income in previous year, up to a max of $29,210||
(Age 50 or over: $7000)
|Carry-Forward Option for Unused Contribution Room||Yes||No||No|
|Before age 71: subject to withholding taxes (WHT)** and income taxes||Before age 59½: subject to 10% penalty tax and income taxes||Before age 59½: subject to 10% penalty tax and income taxes|
Age 72+: RRIF minimum withdrawal is subject to income taxes
Over RRIF minimum withdrawal: subject to
Age 59½: subject to income taxes
Age 72: RMD++ subject to income taxes
Age 59½: subject to income taxes
Age 72: RMD++ subject to income taxes
Based on 2022 contribution room amounts from Canada Revenue Agency (CRA) and Internal Revenue Service (IRS).
*Tax deduction is reduced if contribution room is shared between RRSP and group RRSP and between the traditional IRA and 401(k), respectively.
**Withholding taxes (WHT): 10% up to $5,000 (20% in Quebec), 20% for $5,000 – $15,000 (25% in Quebec), and 30% for $15,000+ (30% in Quebec).
+RRSP rolled over at age 71 to a Registered Retirement Income Fund (RRIF) for mandatory RRIF minimum withdrawals which start in the subsequent year at age 72.
++Required Minimum Distributions (RMDs) are mandatory after age 72 for traditional IRA and 401(k) plans. Exception to RMDs for 401(k) if the person continues to work past age 72 with a current employer.
Cross Border Strategies for Pre-Tax Retirement Accounts
When it comes to pre-tax retirement accounts, a common question asked by Canadians and Americans planning to move, work, or retire across the border is: “What do I do with my pre-tax retirement accounts?” Unfortunately, there is no one-size-fits-all answer to this question since every person’s financial and cross border situation is different. Factors such as which countries you’re a resident of, whether you are planning a move and withdrawal rates, are all factors that need to be taken into consideration.
Strategies should seek to maximize tax savings and to minimize cross border tax traps. But they only work if you choose the option that makes the most sense for your financial situation. Just as you wouldn’t attempt trekking an unknown jungle without help, having a cross border financial planner is highly recommended to guide you in charting and implementing a path to financial success. Whether it’s the jungle or cross border retirement planning, you don’t want to find yourself lost without a well-informed guide.