No area is more complicated for U.S. persons living abroad than the intergovernmental taxation of contributions to, earnings within and distributions from pensions and other retirement plans. In general, most tax treaties allow the country of residence to tax a non-U.S. pension or annuity under its domestic laws. However, there are many wrinkles and variations.
Contributions to Non-U.S. Pension Plans
Although treaties may take a different position, U.S. tax rules dictate that a non-U.S. pension or retirement plan is generally not considered a "qualified retirement plan" for one or both of the following reasons:
- The non-U.S. pension or retirement plan is not structured to conform to the complex rules under IRC Section 401 (e.g., does not include antidiscrimination provisions related to highly compensated employees)
- The trust that holds the plan assets was not created and organized in the U.S.
Absent U.S. qualified plan status, contributions from non-U.S. employers are considered taxable compensation to the employees, and the employees' contributions are not tax deductible. Plan participants in these cases may be comforted to know that if there is no tax deduction or tax deferral of pension contributions permitted by treaty, the current U.S. tax on the contribution may be partially or fully offset by the foreign tax credit.
Earnings Within Non-U.S. Pension Plans
Beyond contributions, the earnings and growth within a non-U.S. pension plan that does not meet the U.S. requirements for a qualified retirement plan are usually taxable in the year they are incurred. So U.S. taxpayers are generally subject to current taxation on income earned in a non-U.S. retirement plan unless the plan is considered a funded employee-benefit trust under IRC Section 402(b) and the individual is not a highly compensated employee.
Taxation of Distributions from Non-U.S. Pension Plans
The U.S. rules regarding distributions from foreign pension plans may be more palatable to U.S. persons. If a U.S. person paid tax on contributions, he or she has a cost basis for distributions and part or all of the distributions may be tax free. However, if a U.S. person participated in a retirement plan while living in the U.S. and did not pay taxes on contributions or internal earnings, but receives distributions while living abroad, the U.S. payer of benefits generally must withhold income tax. The withholding rate is usually a flat 30% for distributions to persons outside the U.S.
Non-U.S. pension plans are often classified as non-U.S. grantor trusts under IRC Section 671. Thus they must be reported on IRS Form 3520 and participants may need to report transactions annually on IRS Form 3520A. However, there are some exceptions, primarily for U.S. persons who live in one of the few countries whose treaties provide comprehensive pension articles. For example, the treaty between the U.S. and Canada may provide for electing out of the grantor trust status. Also, pensions for senior executives may be organized as a funded employee benefit trust under IRC Sec 402(b), which specifically exempts them from being considered a foreign grantor trust. However, these executive plans must contain the required antidiscriminatory provisions for highly compensated employees to be so treated.
Many countries allow pension transfers to and from other countries. However, under U.S. tax rules, such transfers are generally considered taxable distributions.
Reporting and Compliance for Non-U.S. Pension Plans
The trend to global transparency has heightened scrutiny of all non-U.S. assets. Although the initial focus was on individually owned securities, pensions and deferred compensation arrangements may be the next to come under the microscope. Complete reporting and compliance are essential. In brief, U.S. persons with interests in non-U.S. pension plans must usually:
- Report annual income on their individual income tax return (Form 1040)
- Report contributions and distributions on Form 3520
- Report the plan as an asset on FinCen Form 114 and possibly on IRS Form 8938
- File IRS Form 8621 if the pension invested in foreign mutual funds (classified as PFICs)
- File IRS Form 3520A if the pension plan is classified as a foreign grantor trust
In addition, under FATCA (Foreign Account Tax Compliance Act), foreign retirement plans must generally report U.S. account holders to avoid 30% withholding tax on all U.S. source income. Some retirement plans may be exempt under the FATCA regulations, treaties or intergovernmental agreements (IGAs).
Social Security and Medicare Taxes
The rules regarding U.S. Social Security and Medicare taxes (FICA) and their non-U.S. equivalents can be quite complex when dealing with cross-border plans and residences. For contributions, U.S. employers generally must withhold in the same manner as if the employee were working in the U.S.
However, the U.S. has "Bilateral Social Security Agreements" with some countries, including the U.K., Canada, Japan and many of the countries in the European Union (EU). These were developed to eliminate dual coverage and dual contributions for the same work, and to ensure continuity of benefits for workers whose careers have spanned more than one country. These "totalization agreements" typically provide that workers only pay Social Security taxes, or their foreign equivalents, in the country in which they are working. Foreign equivalents to the U.S. Social Security tax are generally a creditable tax for U. S. persons, provided mandatory contributions are based on a percentage of income. However, if these taxes were paid in accordance with a totalization agreement, they are neither deductible nor creditable.
Retirement Planning Strategies for Americans Living Abroad
If you are planning to work outside the U.S. for a number of years, consider freezing contributions to your home country plan while living abroad.
You may be able to claim a foreign tax credit on your U.S. federal income tax return for any foreign income tax withheld from your foreign pension or annuity.
If after repatriating to the U.S. you receive a pension annuity that is paid by a company from a foreign country, you must claim your desired treaty withholding exemption on Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), in the manner specified by the foreign government. If the foreign government or withholding agent refuses to honor it, make the treaty claim on the income tax return you file with the foreign country.
If a U.S. person who is living and working abroad wishes to augment his or her retirement savings, he or she may open and fund an IRA on the same terms as U.S. residents. However, he or she must meet the earned-income threshold for the IRA contribution by having sufficient compensation that may be included in gross income for the year. The threshold cannot depend on earnings which were not taxed due to inclusion in the Foreign Earned Income Exclusion.
Next: Investing and Transferring Wealth Abroad
In the next part of our Wealth Planning for Americans Abroad series, we'll explore the implications of investing while abroad, the tax implications of the Affordable Care Ace and important considerations for proper estate planning.