Is a TFSA taxable for US citizens living in Canada?

Why the IRS taxes a TFSA when Canada does not

A Tax-Free Savings Account is tax-free only under Canadian law. The Canada-US tax treaty protects RRSPs and RRIFs through Article XVIII(7), which lets a US citizen defer US tax on the growth inside those plans, but the TFSA was created in 2009 and was never added to the treaty. To the IRS it is an ordinary investment account with a Canadian label. Interest, dividends and realized capital gains inside it are reported on Schedule B and Schedule D of the 1040 in the year they arise, converted to US dollars.

The reason this stings is the missing credit. On almost every other kind of Canadian income, the Canadian tax you pay is high enough to credit away the US tax through Form 1116. A TFSA produces no Canadian tax at all, so the US tax on its earnings is a genuine out-of-pocket cost. A US citizen in Canada who holds the same investments in a non-registered account would at least have Canadian tax to credit; in the TFSA they have none.

Which US forms a TFSA can trigger

The income tax is the smaller half of the problem. A TFSA can pull in up to four separate reporting regimes, and the penalties for the information returns run independently of tax owing:

• FBAR (FinCEN Form 114). The TFSA is a foreign financial account and counts toward the US$10,000 aggregate threshold, at its highest balance during the year. Our FBAR guide explains the rule for Canadian accounts.
• Form 8938. Once your specified foreign financial assets pass the FATCA thresholds for people living abroad, the TFSA is listed there too.
• Forms 3520 and 3520-A. For years, many practitioners treated a TFSA as a foreign grantor trust, because most Canadian TFSAs are legally structured as trusts, and filed both forms annually. In 2020 the IRS issued Revenue Procedure 2020-17, which exempts certain tax-favoured foreign savings trusts from those forms. Its wording targets plans for retirement, medical, disability or education purposes, and practitioners still disagree on whether a TFSA fits. A TFSA held as a bank deposit or an annuity contract rather than a trust arrangement is not a trust in the first place. The right answer depends on your plan documents and your appetite for penalty exposure, and we treat it as a judgment call made on the file, not a default.
• Form 8621. Canadian mutual funds and Canadian-listed ETFs are passive foreign investment companies. The RRSP exemption from PFIC reporting does not extend to the TFSA, so each fund inside it needs its own Form 8621 every year, with the tax computed under the PFIC rules. Our PFIC answer sets out what that means in practice.

What a TFSA actually costs a US citizen to keep

The real cost depends almost entirely on what sits inside the account. The same account can be a minor nuisance or an expensive annual project:

For most people the last row is the expensive one. The preparation fee for a handful of Forms 8621 can exceed the Canadian tax the TFSA saved, and the PFIC tax itself can be higher than the tax on the same fund held in a taxable account.

Should a US citizen in Canada hold a TFSA at all

Often the honest answer is no, or not in its usual form. A US citizen gets none of the tax-free benefit on the US side, carries the reporting burden every year, and pays US tax on income that everyone else in Canada receives tax-free. Contribution room does not disappear if you leave the account empty, so opting out today does not close the door later, for example after a renunciation.

Where a household wants to keep using the room, three approaches work better than a TFSA full of Canadian mutual funds. First, put savings into the RRSP first, because the treaty protects it; our RRSP answer explains why. Second, if you keep a TFSA, hold only cash, GICs, individual securities or US-listed ETFs inside it, which removes the PFIC layer entirely.

Third, where the spouse is not a US person, the Canadian attribution rules do not apply to TFSA contributions, so a US citizen can give money to a Canadian spouse to contribute to the spouse's own TFSA, keeping the growth outside the US system. Each of these depends on the couple's overall plan, which is why we look at the accounts together rather than one at a time.

How we handle TFSAs on the returns we prepare

We start by asking how the plan is legally structured and what it holds, because those two facts decide which forms apply. We report the income annually on the 1040, prepare Forms 8621 for any Canadian funds, include the account on the FBAR and Form 8938, and document the position we take on Forms 3520 and 3520-A so it is defensible if the IRS asks. Where the account is doing more harm than good we say so and help move the holdings into a structure that works in both countries. The wider context for US citizens living here is in our dual citizen tax guide, and the yearly service is described on the US tax preparation page.

Source: IRS - Revenue Procedure 2020-17.