For Canadians who have lived or worked in the United States, US-based retirement accounts such as 401k’s and IRAs often form a significant part of their retirement portfolio. However, when moving back to Canada – or even just retiring as a Canadian resident – how and where these funds are held can have major tax consequences.
One of the most common (and costly) oversights we see in cross-border financial planning is the rollover of a 401k to an IRA – without realizing that doing so can eliminate access to valuable Canadian tax benefits like pension income splitting.
In this post, we’ll explore the key differences between 401k and IRA distributions under Canadian tax law, how the Canada-US Tax Treaty plays a central role, and what strategies Canadians should consider before moving or consolidating retirement assets.
The Core Issue: Not All US Retirement Income is Treated Equally in Canada
Under Canadian tax rules, certain types of income – including qualifying pension income – can be split between spouses for tax purposes once the taxpayer reaches age 65. This allows couples to reduce their overall tax burden by shifting income from a higher-income spouse to a lower-income one.
But here’s the catch: not all foreign retirement income qualifies.
If you’re a Canadian resident withdrawing directly from a 401k, you’re generally in luck. But if you rolled that same 401k into an IRA, those same withdrawals may no longer be eligible for pension splitting.
The Treaty Framework: Article XVIII(5) of the Canada-US Tax Treaty
The key legal mechanism governing this difference is Article XVIII of the Canada-US Tax Treaty, which outlines how various types of retirement income are treated between the two countries.
Specifically, Article XVIII(5) states:
“Pensions and annuities arising in one Contracting State and paid to a resident of the other Contracting State may be taxed in that other State…”
Canada interprets this to mean that periodic payments from a US “pension or retirement arrangement” are treated as pension income under Canadian tax rules.
This is important because, under subparagraph 60(l)(v) of the Income Tax Act (ITA), pension income received from a foreign pension plan is eligible for special treatment, including:
- Pension income splitting under section 60.03 of the ITA
- The $2,000 federal pension income credit
However, not every US retirement account qualifies under this provision.
Why 401k Distributions Qualify for Pension Splitting
A 401k is considered an employer-sponsored pension plan under both US and Canadian tax frameworks. Because it meets the following criteria, distributions from a 401k are generally treated as foreign pension income in Canada:
- It is sponsored by an employer
- It is a recognized retirement plan under US tax law
- It is subject to employer/employee contributions and restrictions
Therefore, when a Canadian resident receives distributions from a 401k after age 65, those payments:
- Are treated as pension income under the ITA
- Qualify for income splitting with a spouse or common-law partner
- May be eligible for the federal pension credit and related provincial credits
Why Rollover IRA Distributions Do Not Qualify
Here’s why many retirees unintentionally sabotage their own tax efficiency.
When a 401k is rollover over into an IRA, the account technically changes form. Although the rollover is tax-deferred in the US, Canada treats the resulting IRA differently.
An IRA is considered a personal savings plan, not a pension. It is not employer-sponsored and does not meet the same Treaty criteria.
As a result, CRA typically treats IRA withdrawals as ordinary income, not pension income. Therefore:
- Rollover IRA withdrawals do not qualify for pension splitting
- They may not be eligible for the pension income credit
- Taxable income cannot be shifted to a lower-income spouse
Even worse, once the funds are inside an IRA, you cannot roll them back into a 401k unless you resume employment with a qualifying employer in the US – which is unlikely for most retirees.
The Cost of the Mistake
Let’s take an example:
A Canadian couple returns to Canada at age 65. One spouse has $800,000 in a 401k, which they begin drawing down at $80,000/year. If that income qualifies for splitting, they can report $40,000 each – likely keeping both in a lower marginal tax bracket and reducing OAS clawback exposure.
But if the 401k had been rolled into an IRA before returning to Canada?
The entire $80,000 would be taxed in the hands of one spouse – potentially pushing them into a higher bracket and increasing their effective tax rate by thousands of dollars annually.
Key Planning Takeaways
- Don’t roll your 401k into an IRA before speaking to a qualified cross-border professional
- If you’re already in Canada with a 401k, you can generally start drawing from it at age 59½ and split income once you or your spouse turn 65
- Work with a cross-border financial planner before consolidating or withdrawing from US accounts – what’s tax efficient in the US may be tax-inefficient in Canada
- Keep documentation of the plan’s origin (i.e. that it was a 401k) in case the CRA requests evidence for pension income treatment
Final Thoughts
Cross-border retirement planning is full of subtle traps, and the 401k-to-IRA rollover is one of the most common – and avoidable. While IRAs may offer more investment flexibility or lower fees in the US, the Canadian tax consequences can far outweigh those benefits.
Before you move funds, consolidate accounts, or make withdrawals, consult with a qualified cross-border financial planner who isn’t incentivized to encourage you to roll your 401k to an IRA which they can manage for a fee. The right structure can preserve access to income splitting, reduce your tax bill, and increase your after-tax retirement income.
Need help navigating your cross-border retirement strategy? Let’s talk.