Alert for Parents: Education Savings Plans and U.S. Tax Issues
Children. From the moment they’re born you start planning for their future. And like a lot of good parents, you start to save money for their future education early. Both Canada and the U.S. have great education savings programs whereby generally any plan earnings are tax-deferred until Junior goes off to post-secondary education. But tax problems can arise with these education savings plans when you have to file tax returns in both Canada and the U.S., or you move from one country to another.
Children. From the moment they’re born you start planning for their future. And like a lot of good parents, you start to save money for their future education early. Both Canada and the U.S. have great education savings programs whereby generally any plan earnings are tax-deferred until Junior goes off to post-secondary education. But tax problems can arise with these education savings plans when you have to file tax returns in both Canada and the U.S., or you move from one country to another.
What you Need to Know About U.S. Reporting Requirements for RESPs and RDSPs
Scenario: U.S. Citizen Resident in Canada with RESPs
Assume you are a well-intentioned parent of two looking to make sure you can help finance your children’s university education. You also happen to be a U.S. citizen, but you live in Canada. Your U.S. citizenship means you must file both Canadian and U.S. tax returns reporting your worldwide income in both. You thought you had met your U.S. tax filing obligations but you also recently opened a Canadian Registered Education Savings Plan (“RESP”) for your children. Because there is no tax reporting requirement attached to the RESP for you in Canada, and the earnings are tax-deferred in the RESP, you assumed that there was nothing to report to the U.S.
Wrong. Unfortunately, your assumption is incorrect. RESP’s, Registered Disability Savings Plans (“RDSP”), and certain other entities, including family trusts, that are resident outside the U.S. have special U.S. tax filing obligations. Under US tax law the penalty for failing to make these disclosures is the greater of $10,000 or 35% of amounts transferred to the entity (IRS Form 3520) and an additional penalty (IRS Form 3520-A) which is the greater of $10,000 or 5% of their gross value.
So not only is the income inside the RESP taxable on your U.S. tax return, but your failure to file IRS Forms 3520 and 3520-A mean you face potential significant penalty exposure, in this case, $20,000.
The good news is that it may be possible to get your U.S. tax filings corrected without being subjected to penalties.
From an after-tax perspective RESPs may not be an attractive investment vehicle for U.S. persons even without the additional costs to comply with US tax law.. For US tax purposes the earnings in RESPs are taxed back to the grantor, typically the parent, but for Canadian tax purposes they are taxed to the beneficiary. Because the tax in the two countries are paid by different persons they cannot offset each other resulting in double taxation.
W.L. Dueck & Co. LLP can help you determine how to get you into compliance with U.S. tax filing requirements and evaluate the attractiveness of using RESPs, RDSPs and other investment vehicles.
