For many US expats, taxes are out of sight and out of mind for most of the year.
But as the 15 June filing deadline approaches, Evan White, tax attorney at H&R Block says (as first published in the May edition of International Investment), that it might be a good time to consider what some of the tax implications are for Americans who are about to, or expect to, retire abroad.
Even if your American clients are not yet coming up on retirement age, it is worth understanding some of the American system’s rules, in order to help them to avoid some potentially costly headaches in the future.
Retirement arrangements around the world share a basic structure: the individual (and maybe their employer) contributes to a pension arrangement throughout their working life, these contributions grow over time, and they receive payments after they reach retirement age – whatever that is in their current jurisdiction.
Due to the importance of retirement savings in looking after people when they are elderly, countries often incentivise these arrangements through their tax codes.
For example, contributions to a retirement plan may be tax-deductible or tax-free; earnings will likely accrue on a tax-deferred basis; and in some cases, payments from the plan are either tax-free, or subject to preferential tax rates.
While this basic structure is fairly uniform around the world, there is one area for American expatriates with US filing obligations that is not straightforward: and that is the tax implications that come with their being enrolled in a foreign pension plan.
US treatment of Non-US pensions
Many US expats (and sometimes even their overseas advisers) assume that their foreign pensions are not taxable in the US, or that the US affords tax treatment similar to that of the country in which the pension is located.
However, because the US tax code is based on the concept of worldwide income, these arrangements must be viewed through the lens of generally applicable US tax laws.
This means that foreign pensions generally fail to meet the requirements to be “qualified” in the US, and as a result, they do not enjoy the favorable tax treatment provided to other, “qualified” plans, like IRAs (individual retirement accounts) or 401(k) plans.
Instead, they are generally taxed as trusts, annuities or simply, as taxable investment accounts.
When a foreign pension fails to satisfy the requirements to be, as they say, “qualified” for US tax purposes, there are a number of issues that should be considered.
For this reason, as individual American expatriates – and their advisers – weigh their retirement savings options, they need to keep the following points in mind:
- Contributions – When an expatriate’s employer provides contributions to a pension arrangement, those contributions are treated by the US tax system as additional wage income when they “vest”.This is true even where those contributions are tax-deductible or tax-free under the laws of the local country.
- Information Reporting – There are a number of information reporting obligations that come along with holding a non-US pension, if someone happens to be an American citizen or has American reporting obligations.Most pensions are regarded by the US tax system as “reportable accounts” that should be included on the individual’s annual FBAR (foreign bank account report) each year.Additionally, if their foreign pension is treated as a trust for tax purposes, there is a more involved set of forms that would need to be filed each year along with their tax return.
It’s important to note that failure to file these forms could create a substantial penalty exposure for the individual in question.
- Look Through Rules – Depending on the manner in which a particular expatriate American’s pension arrangement is structured, and the level of control they are able to exercise over the underlying investments, they may be treated as the direct owner of the assets held in their retirement plan.
If that were to be the case, any income they earned in their pension would be taxable to them in the year it was earned, even if it remained undistributed.
- Distributions – If the “look through rule” described above does not apply to a particular expatriate American’s pension, distributions that they receive will generally be taxable for US purposes.If the pension contributions and earnings have not already been subject to US tax, the distribution may be wholly or only partially taxable.
Foreign Tax Credits
There are four events relating to a foreign pension that can create taxable income for an American expatriate. They are: pension contributions, pension distributions, pension transfers, and, when the “look through rule” applies, income generated by plan assets.
Fortunately, even if an American expat’s non-US pension generates some taxable income, they may be able to avoid paying US tax by claiming a foreign tax credit.
Indeed, it may even be desirable to for pension contributions to be classified as currently taxable income from their pension, if they have a sufficient foreign tax credits to cover the US tax exposure.
While the US reserves the right to tax an American expat’s worldwide income, it also allows for a dollar-for-dollar reduction of US tax for any income taxes paid to a foreign government on that American expat’s foreign income. So, if a particular item of income is taxed by a foreign government, the American expat would only have a US tax bill if the US tax assessed on that income were to exceed the foreign tax assessed.
And if that individual were to pay more to the foreign government than they did to the US, that excess may be carried back one year, or carried forward and used sometime during the next ten years.
In this way, the foreign tax credit limits double taxation on foreign earnings.
In addition to enabling the expatriate to avoid being taxed twice on the same income, the foreign tax credit from some foreign earnings can also be used to offset the tax owed on other foreign earnings.
For American expats living in a high tax country, this may present a planning opportunity that can be used to reduce their taxes in retirement.
This is achieved by creating certain kinds of tax events, that enable the expat to use their foreign tax credit carryovers to offset income created by their non-US pension. This allows them, therefore, to both harvest foreign tax credit carryovers that would otherwise lapse, while also reducing the portion of their (foreign) pension income that would be taxable in retirement.
It is a common misconception that most income tax treaties provide US tax deferral for expat’s foreign pensions. While this may be true in a number of countries, many income tax treaties do not provide relief to US expats with foreign pensions.
Currently, the US has income tax treaties with five countries that provide for tax-deferral of income generated by US expats’ foreign pensions in those countries. Those countries are Canada, Germany, Belgium, the United Kingdom and the Netherlands.
Evan White is a tax attorney and region manager for Australia, Brazil, Hong Kong and Singapore with H&R Block Expat Tax Services. He specializes in business, investment, foreign pension and informational reporting for American expats.