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Tax Guide

U.S Tax Impact from portability between non-US retirement plans

U.S Tax Impact from portability between non-US retirement plans
Ines Zemelman, EA
25 February 2020

Transfer of funds from one pension plan to another may be treated a taxable event in the US (there is no official document to substantiate the tax exemption).

Introduction

Many Americans are working abroad. Many of them will be participating in the retirement plan in a foreign workplace which they believe is similar to a section 401(k) plan in the US.  Most taxpayers make crucial mistakes believing that IRS treats foreign retirement plans just like domestic ones as the IRS does not generally tax contribution to foreign plans, the accumulated yet undistributed income in foreign plans and distribution from foreign plans.

Normally US expats do the following steps on the suggestion of US accountant who lacks extensive experience with  international tax matters

  1. Filing timely form 1040 reporting the wages from the foreign company
  2. Disclosing the existence and location of the foreign savings account on Form 1040 Schedule B(Interest and Ordinary dividends)
  3. Claiming the foreign earned income exclusion on Form 2555
  4. Reporting the interest income from the Foreign savings account
  5. Filing electronically an annual FinCEN form 114 to notify the IRS about the foreign savings account

A US accountant may mistakenly assume the foreign retirement plan is similar to sections 401(K) plan in the US and thinks will not have any issues until they start distribution from the plan. US expats will make the maximum annual contribution to the Foreign plan and the amount in the plan continues to grow and also gains on passive investments.

If the lack of tax deferral is not enough to get your attention, there should be a long-list of information reporting duties and the steep penalties for violations.

Based on a recent study by the US Government Accountability Office (GAO Report) criticizing the IRS and Congress for allowing the perpetuation of a complex, obscure and inconsistent system. The US tax and information reporting problem of US persons with foreign retirement plans are well documented in the GAO report issued in Jan 2018. The GAO reports start by underscoring the size of the problem, there are nearly nine million US citizens living abroad, many of whom have interests in local retirement instruments. It then describes the distinct way that the US tax system treats domestic versus foreign retirement plans. The GAO report says that - contributions by employees and employers and passive earnings such as interest, dividends and capital gains within a qualified retirement plan generally are not taxed until the employee receives the actual distribution from the plan. By contrast, the GAO report says that Foreign workplace retirement plans are not ordinarily considered “qualified plans” under the IRC so US expatriates working as employees do not receive the same benefits as their counterparts with “qualified” domestic plans.

Tax treatment of foreign pension plan

Depending on several factors, including the characteristics of the plan, local law, and the provisions in the applicable bilateral treaty, US individuals who participate in foreign retirement plans might be taxed currently on

  1. Contribution to the plans, by themselves or their employers
  2. The accrued but undistributed earnings in the plans and
  3. The distributions from the plans that they have not actually received, such as transfers of assets between or among various foreign plans

Some points from the GAO Report

  1. GAO report acknowledges that the IRS has provided some limited guidance about foreign workplace retirement plans, such as the International Tax Gap Series and Pub 54 - Tax guide for US citizens and Resident Aliens Abroad. However the GAO report says that neither of these “describes in detail how taxpayers are to determine if their foreign workplace retirement plan is eligible for tax deferred status or how to account for contributions, earnings or distributions on their annual US tax return, particularly whether and when contributions and earnings should be taxed as income.
  2. GAO report also indicates that, while the IRS directs taxpayers to review the relevant bilateral tax treaties for any provisions related to foreign pensions, even IRS officials admit that “ these treaties can vary from country to country and can be difficult for nonexperts to understand.
  3. GAO report confirms that foreign workplace retirement plans are not generally considered qualified plans for US tax purposes and thus are not entitled to the corresponding tax benefits. The GAO report says in this regard
    “IRS officials told us that U.S. tax law generally does not recognize foreign retirement plans as tax-qualified and IRS does not recognize any retirement accounts outside the United States as having tax-qualified status. IRS officials we spoke to said that only plans meeting the specific requirements of [Section] 401(k) or other requirements describing retirement plan qualification may achieve tax-qualified status in the United States. As a result, according to IRS guidance, U.S. individuals participating in foreign workplace retirement plans generally cannot deduct contributions to their accounts from their income on their U.S. tax return. This is true even if the retirement account is considered a tax-deferred retirement account in the country where the individual works, and even if the account is similar in nature to those found in a U.S.-type retirement plan, such as a [Section] 401(k) plan.”
  4. According to the GAO report, some practitioners advise their clients to report them as passive foreign Investment companies on Form 8621 (return by US shareholder of a PFIC). Others recommended disclosing them as the foreign financial account on FBARs and Form 8938. While still others suggest that they should be treated as foreign trust and reported on Form 3520 and 3520A

To Exacerbate matters, the GAO report, citing warnings from the national taxpayer advocate, says the IRS might abate penalties related to the erroneous treatment of foreign plans in situations involving reasonable reliance by a taxpayer on a qualified, informed, US tax professional. However “ receiving incorrect tax advice from a foreign tax preparer may not be a sufficient mitigating circumstance to avoid penalties for reporting a foreign retirement account incorrectly on a tax return. Tax preparers in other countries are not considered qualified preparers by the IRS.

GAO report sticks with the IRS and does not  consider tax preparers in other countries as qualified. The taxpayers are ultimately liable for getting things right, notwithstanding the complexity of the issues, lack of IRS guidance and the confusion among tax professionals about how to treat foreign retirement plans “ IRS officials told us that individual taxpayers are responsible for understanding their filing requirement and for determining how to correctly file their tax return, regardless of whether they live in a foreign country or the US.

Read The Tax Treaty Closely

Full portability (transfer of pension between plans) between foreign retirement plans is tax-free only in several countries where such provision is included in the tax treaty that contains the following wording:

“Where an individual who is a resident of a Contracting State is a member or beneficiary of, or participant in, a pension scheme established in the other Contracting State, income earned by the pension scheme may be taxed as income of that individual only when to the extent that it is paid to, or for the benefit of that individual from the pension scheme (and not transferred to another pension scheme).”

UK and Belgium are the only countries where it is clear

Such wording can only be found in tax treaties with the UK and Belgium. For the rest of the world, including 3 other countries with IRS-qualified planes, the issue is still open, and transfer of funds from one pension plan to another may be treated as a taxable event in the US - because there is no official document to substantiate the tax exemption.

In January 2018, the GAO requested that the IRS clarify how U.S. taxpayers report their participation in foreign plans for U.S. tax purposes. Among other suggestions, the report also recommends that Congress consider changing the tax law to allow tax-deferred transfers between foreign plans.

Congress should consider legislation modifying the Internal Revenue Code to allow routine account transfers within the same foreign workplace retirement plan or between two foreign workplace retirement plans in the same country to be free from U.S. tax in countries covered by an existing income tax treaty that provides for favorable U.S. tax treatment of foreign workplace retirement plan contributions.

The issue is still open.

Caution is advised

For now, we advise that such a transfer may be treated as a taxable event in the US, pending further updates from the IRS.

Ines Zemelman, EA
founder of Taxes for Expats