Tax Issues of a Tax Free Saving Account(TFSA) for US citizens living in Canada

A TFSA allows Canadian residents who are 18 or older to set money aside to earn investment income that would not be subject to Canadian tax/ The annual TFSA contribution limit is $6,000 at present. However US citizens who living in Canada should be aware that, unfortunately, a TFSA is neither a tax-free nor a tax deferred account for U.S. tax purposes.

Income received or capital gains realized each year must be reported on your U.S. income tax return. Where a TFSA is a financial account, in addition to being taxed annually on the income, it must generally be included in your FBAR filing. When a TFSA is set up legally as a trust, if the IRS views the TFSA as a foreign trust with a U.S. owner, the account owner may be subject to additional reporting requirements.

For example, suppose that JD has invested $5,000 in his TFSA for 2020, his first year of contributions, and he has no other passive income. If he earns interest at 5 percent and if he has a Canadian marginal income tax rate of 50 percent, she will save $125 of Canadian tax. On the other hand, if he 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 his cost of US filing increases by $565 ($500 per form plus 13 percent GST/HST). If so, investing in the TFSA will have cost JD $503 instead of saving him $125.

However, the TFSA may still be a beneficial vehicle for US citizens residing in Canada if the individual has foreign (such as Canadian) taxes payable on other non-US investment income (held outside of a TFSA), as the foreign taxes payable on that other non-US investment income may be applied to offset some of the US income tax attributable to the TFSA income.

TFSA is subject to FBAR reporting as it is a foreign financial account for purposes of reporting the account on a US taxpayer’s FinCEN Form 114, because the contributor has a direct financial interest in the plan. Failure to disclose the account can result in significant penalties. TFSA is also have to be reported on FATCA Form 8938, also known as the Statement of Specified Foreign Financial Assets. Failure to disclose the account can also result in penalties.

Many practitioners have assumed TFSA is a foreign trust for US tax purposes and is required to file Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, and Form 3520-A, Annual Information Return of Foreign Trust With a US Owner.