Debunked: Four myths about retirement plans and foreign workers
Workers who temporarily live in the U.S. will owe U.S. taxes when they transfer their retirement funds between foreign and domestic plans
Editor’s note: This article has been reviewed for changes following the passage of the 2017 Tax Cuts and Jobs Act. The information provided in this article was not affected by the 2017 TCJA.
Doing taxes as a permanent U.S. resident is confusing enough. Add retirement plan rules into the mix, and most people seek professional help. In this globally connected era, more workers are moving freely to work outside of their home countries – staying abroad on nonimmigrant work visas from a few months to more than a decade. During that time, it’s typical for workers to amass funds in retirement accounts, contributing their own money and adding employer contributions.
Workers coming to the U.S. will usually become U.S. residents for tax purposes while they’re here. They become U.S. residents when they meet the green card test or substantial presence test. After that, they’ll owe taxes on worldwide income. They’ll also usually file a Form 1040 reporting their worldwide income, including distributions from foreign and domestic retirement plans.
Some foreign workers mistakenly think they can transfer money from their foreign retirement plans into U.S. plans, or vice versa, without owing taxes, like a qualified rollover in the U.S. They do this to try to defer taxation on the funds under the laws of either country until they withdraw the funds in retirement.
But moving money between foreign and domestic retirement plans is more complicated than that. Here are four of the most common myths about these transactions, and their realities.
Myth 1: “I can’t open a U.S. retirement account because I’m not a U.S. citizen.”
This isn’t true. You don’t have to be a U.S. citizen to open a U.S. retirement account. Resident aliens can open U.S. retirement accounts, including people on nonimmigrant visas. But there are a couple caveats to note.
Resident aliens must have earned income to open a U.S. retirement account. Earned income includes taxable salary, wages, self-employment, and alimony. Some U.S. tax treaties may affect what counts as earned income, because some treaties exempt certain income from U.S. taxation.
Also, to open a U.S. retirement account, resident aliens must have a Taxpayer Identification Number (TIN), such as a Social Security Number (SSN) or an Individual Taxpayer Identification Number (ITIN). If an individual isn’t eligible to receive an SSN, he or she would need to get an ITIN.
Myth 2: “As a U.S. resident, I can roll over funds from my foreign retirement plan into a U.S. plan, tax free.”
This is false. U.S. residents with a U.S. qualified retirement plan generally won’t owe taxes on certain distributions they receive during the year, if they transfer the distributions into another U.S. qualified plan. This transfer can be a direct transfer, trustee-to-trustee transfer, or a 60-day transfer.
But foreign retirement plans usually don’t meet the qualified plan rules, because the plan’s trust is housed in a foreign country. In that case, if a U.S. resident tries to transfer funds from a nonqualified foreign plan into any U.S.-based qualified plan, the transfer is still taxable even if all other requirements are satisfied.
Distributions are taxed under the general rule
If the distribution is taxable in the U.S., then the taxable portion is calculated under the “general rule” for retirement annuity distributions. The taxable amount is the gross distribution minus the allocable share of its cost (after-tax investment in the contract).
If both countries tax the attempted transfer, then the U.S. resident may qualify to claim the foreign tax credit. The foreign tax credit is a nonrefundable credit with a carryover provision. It’s intended to relieve double taxation by the U.S. and a foreign country. Usually, resident aliens can take the credit for the foreign income taxes they paid on the income they earned in the U.S.
Foreign retirement plans, except for foreign social security and foreign government-defined benefit plans (such as certain “Tier” or “Pillar” pension plans), are also reportable under the Report of Foreign Bank and Financial Accounts (FBAR), Form 8938, and Form 1040, Schedule B, Part III. This procedure applies to the distribution, as well.
Myth 3: “My home country has a tax treaty with the U.S., so my foreign retirement plan transfer isn’t taxable in the U.S.”
It depends. The U.S. signs tax treaties with foreign countries to define how the countries will treat tax issues between the nations. Treaties sometimes address the tax treatment of retirement plans and other types of information reporting. For foreign workers and their advisors, it’s a good idea to examine the specific tax treaty to determine which country can tax retirement plan distributions.
Under most U.S. tax treaties, with certain exceptions, retirement plan distributions and other earnings paid to a U.S. treaty resident (as determined under the treaty rules) will be taxable only in the U.S. Each treaty has its own rules on U.S. residency, so taxpayers and their advisors should consult each treaty.
Just two U.S. tax treaties (with South Africa and the United Kingdom) contain an article on taxing retirement plan transfers. If the treaty doesn’t contain a provision for rollovers, then the country where the taxpayer officially resides under the tax treaty will tax the transfer as a distribution under its laws.
Myth 4: “I closed out my U.S. retirement account and transferred the funds to a retirement account in my home country. I can exclude this transfer on my U.S. return.”
This usually isn’t true. When workers return to their home countries and transfer their U.S. retirement plan balances into foreign retirement plans, these rollovers generally don’t qualify for exclusion from tax, and are taxable in the U.S., unless a tax treaty provides otherwise.
Also, if the nonimmigrant visa holder is a longtime resident, the expatriation rules may apply, causing the individual to be subject to U.S. taxation after leaving the U.S.
Get the facts
Taxation of retirement plan transfers between U.S. and foreign plans can get complicated. The first thing foreign workers and their advisors should do is check the tax treaty (if one exists) between the U.S. and the foreign country. Then, they can plan accordingly to avoid any surprises at tax time.