Registered Education Savings Plans (RESPs) are a popular savings vehicle for Canadian residents, offering tax-sheltered growth to fund post-secondary education. However, U.S. citizens and residents face a different reality when it comes to RESPs. These accounts, which are straightforward under Canadian law, create a web of complex U.S. tax rules and tax considerations, requiring meticulous attention to reporting obligations and filing requirements.
This article breaks down RESP taxation, the intricacies of annual reporting, and the impact of Revenue Procedure 2020-17.
What is a Registered Education Savings Plan (RESP)?
An RESP is a tax-advantaged savings account under Canadian law, designed to help families save for post-secondary education. While contributions to the RESP are not tax-deductible in Canada, investment income and the Canada Education Savings Grant (CESG) grow tax-free until they are withdrawn, at which point they must be reported on a Canadian income tax return.
Under trust definition rules, RESPs are classified as grantor trusts, which would normally require the filing of Form 3520. Indeed, we used to file these forms (3520 and substitute 3520-A).
RESPs are one of the tax-favored foreign plans described under Revenue Procedure 2020-17; while Revenue Procedure 2020-17 doesn’t change the taxation of the RESP, it waves the from 3520 filing requirement.
The key aspects of RESP taxation in the U.S. are:
- Income earned in an RESP is taxed the same way as income earned in a non-registered account in your name. An RESP would be a grantor trust, with the parent treated as a US owner, due to the fact that if the child beneficiary has attained a certain age, or should the child beneficiary decide not to attend post-secondary studies, the corpus and income of the trust can revert to the parent sponsor(s).
- You must still adhere to their income tax filing obligations (FBAR, FATCA).
- Reporting obligations like FATCA and FBAR remain in place, but Forms 3520, 3520-A, are no longer required.
How Are RESPs Taxed in the US?
While Registered Education Savings Plans (RESPs) offer tax advantages under Canadian law, they face distinct treatment under U.S. tax regulations.
RESPs are classified as foreign trusts, grantor trusts to be specific, with the US parents being treated as US owners.
Before Revenue Procedure 2020-17, the US owner had to file Forms 3520 and 3520-A to disclose their interest in the trust.
However, Revenue Procedure 2020-17 doesn’t change the taxation. As was the case, income earned within the RESP, such as interest, dividends, and capital gains, is taxed annually by the U.S.
RESP investments, such as mutual funds or ETFs, might also be subject to passive foreign investment company (PFIC) rules. These rules require additional reporting through Form 8621 and often lead to punitive tax consequences, including taxation at the highest marginal tax rate.
For an investment to be a PFIC, it has to be classified as a corporation under US entirety classification rules.
This requires the entity to have limited liability at the time of inception. In many cases, there are uncertainties as to whether an investment would be classified as a corporation, and if it was not a corporation, it wouldn’t be a PFIC.
Feel free to contact us to discuss it further.
Impact of Revenue Procedure 2020-17
In March 2020, the IRS issued Revenue Procedure 2020-17, which provided relief for certain tax-favored foreign trusts, including RESPs. Per Section 5.04 of this procedure, a foreign trust is deemed a tax-favored foreign non-retirement savings trust if it meets the following criteria:
- Established Under Foreign Law: The trust is created or organized under the laws of a foreign jurisdiction to operate exclusively or almost exclusively to provide, or to earn income for the provision of, medical, disability, or educational benefits.
- Contribution Limits: Contributions to the trust are limited by the foreign jurisdiction’s laws to specified amounts or are subject to other contribution limits.
- Purpose of the Trust: The trust operates exclusively or almost exclusively to provide, or to earn income for the provision of, medical, disability, or educational benefits.
- Tax Reporting: Contributions to, and income of, the trust are subject to tax reporting under the laws of the foreign jurisdiction or are eligible for beneficial tax treatment.
RESPs generally meet these criteria, as they are established under Canadian law to provide educational benefits, have contribution limits, and are subject to Canadian tax reporting.
Current U.S. Tax Treatment of RESPs
The introduction of Revenue Procedure 2020-17 by the IRS significantly altered the treatment of RESPs. Specifically, Section 5.04 of this revenue procedure recognizes RESPs as tax-favored foreign non-retirement savings trusts, provided they meet specific criteria. As a result, these plans are no longer subject to Form 3520 filing requirements. The exemption eliminates the need for Forms 3520 and 3520-A, simplifying the compliance burden for RESP holders.
Reporting Obligations for RESPs on Income Tax Returns
While Revenue Procedure 2020-17 removed the reporting obligations associated with foreign trust classification (Forms 3520 and 3520-A), RESP holders must still comply with other U.S. tax rules, including:
- FATCA Compliance (Form 8938):
- RESPs must be reported if the aggregate value of specified foreign financial assets exceeds $200,000 for U.S. citizens living abroad ($50,000 for those living in the U.S.). This ensures that all relevant foreign financial assets are disclosed, aligning with the Financial Crimes Enforcement Network’s requirements.
- FBAR Filing (FinCEN Form 114):
- If the RESP’s value, combined with other foreign financial accounts, exceeds $10,000 at any time during the tax year, it must be reported under FBAR rules. This is crucial for maintaining compliance with U.S. tax laws regarding foreign accounts.
- Income Tax Reporting:
- Any income earned within the RESP must be reported on the taxpayer’s income tax return. Earnings and grants, such as the Canada Education Savings Grant (CESG), are treated as ordinary income. These are included in gross income and reported on Form 1040, impacting the individual’s taxable income for the year. Careful attention to these reporting obligations is essential to avoid penalties and ensure compliance with the Internal Revenue Service’s tax rules.
How Can You Avoid Double Taxation on RESP Income?
RESP income may be subject to double taxation, first by the Canada Revenue Agency (CRA) upon withdrawal and then by the Internal Revenue Service (IRS) as part of the account holder’s or beneficiary’s worldwide income. To mitigate this risk, proactive steps must be taken:
- Claim Foreign Tax Credits (Form 1116):
You can offset U.S. tax liability by claiming a foreign tax credit for the Canadian taxes paid on RESP withdrawals. While this can reduce your U.S. tax burden, it may not entirely eliminate it, especially if the U.S. tax rate exceeds the Canadian tax rate. - Leverage Tax Treaty Provisions:
Although the U.S.-Canada Tax Treaty does not explicitly address RESPs, its general provisions provide relief by allowing credits or deductions for taxes paid to the other country. This helps to prevent outright double taxation. - Engage in Strategic Tax Planning:
Consult with a knowledgeable tax professional to optimize the timing of RESP withdrawals. By aligning withdrawals with years of lower taxable income or maximizing available credits, you can ensure better tax efficiency and minimize your overall liability.
By using these strategies, RESP holders can effectively reduce the impact of double taxation and navigate the complexities of cross-border tax obligations.
Need Help with RESP Taxation? Contact Us for Free Tax Consultations
Understanding the U.S. taxation of RESPs can be complex, but we’re here to help. At 1040 Abroad, we offer free tax consultations for U.S. expats to simplify cross-border tax obligations, including RESP reporting, foreign tax credits, and compliance with U.S. tax laws.
Have questions? Contact us today for expert advice tailored to your needs, and let us make your tax journey stress-free!
