What Happens When You Inherit an IRA or 401(k)?

Spouse beneficiary

When a spouse inherits an IRA or 401(k), he or she can inherit the account as an inherited account or transfer the account to his or her own IRA or 401(k) on a tax-deferred basis.

IRA and 401(k) accounts generally require minimum distributions (RMDs) beginning at age 73. These are subject to US withholding tax for a Canadian resident, and Canada taxes the withdrawal with a credit towards US tax already withheld.

A US citizen living in Canada must report their worldwide income on both a Canadian and US tax return.

Non-spouse beneficiary

When a non-spouse beneficiary inherits, the account value is not subject to immediate tax. This differs from the taxation of an RRSP, DC pension or other Canadian retirement accounts for non-spouse beneficiaries. These Canadian retirement accounts are generally fully taxable to the deceased’s estate.

Instead, taxes are due on subsequent withdrawals from the inherited IRA or 401(k). This can provide an opportunity for tax deferral, but also for a possible reduction in the tax rate payable. A deceased Canadian taxpayer with a high income in the year of death may pay more than 50% tax on his tax-deferred pension. A non-spouse beneficiary with a low or moderate income may pay a significantly lower tax rate.

There is a ten-year rule that allows withdrawals to be taken over up to ten years after the death of the account holder. In the meantime, the bill remains tax-deferred in the US and Canada.

US withholding tax

The withholding tax on distributions from U.S. retirement accounts to nonresidents is typically 30%; However, a Canadian beneficiary may submit Form W-8BEN – Certificate of Foreign Beneficial Ownership Status for U.S. Tax Withholding to the financial institution. This allows them to withhold the lower rate of 15%.

This is important because Canada will only allow a foreign tax credit at the 15% treaty rate. If a higher rate is withheld, a beneficiary may need to file a U.S. tax return to receive a refund from the Internal Revenue Service.

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Inherited Roth IRAs

A Roth IRA is like a Canadian tax-free savings account (TFSA). A spouse’s beneficiary can take over the account or transfer it to their own Roth IRA.

Roth IRAs are generally tax-free in the US and may also have tax-free status in Canada; however, an account holder must apply to the Canada Revenue Agency (CRA) to maintain tax-exempt Canadian status and ensure no new contributions are made.

A non-spouse who inherits has the same CRA election requirement, but has a different option for tax-exempt status. There is a ten-year rule for non-spouse beneficiaries, which only allows for a limited tax-free growth period.

Roth IRA withdrawals are tax-free in the US and Canada.

Exceptions

Disabled or chronically ill non-spouse beneficiaries may be exempt from the ten-year rule.

For minor beneficiaries, the ten-year clock does not start running until they reach adulthood.

Summary

IRA and 401(k) accounts work slightly differently than Canadian RRSP, DC pension and TFSA death accounts. These US counterparts offer more favorable options for tax cuts.

If you expect to leave a US account as an inheritance, or if you inherit one of these accounts, it is important that you understand the rules. They can affect how you build your wealth in retirement and how you structure your estate.