How to determine the US tax consequences of your foreign pension, retirement plan, or social security-type benefits
The first inquiry is if your foreign retirement it a defined benefit plan or a defined contribution plan.
With a defined benefit retirement plan you don’t have an account, do you? So can’t have an account value either right? So we really shouldn’t see any requirements for foreign reporting forms like a Form 8938 and an FBAR form as there are no numbers to put in. If we are dealing with a defined benefit retirement plan, typically our work is much easier and the consequences for getting something wrong are much less severe.
No if you do have a defined benefit retirement plan, contributions into that plan are usually treated as income. Yet, unlike earned income, this income can typically not be excluded by the foreign income exclusion. However, foreign tax credits may still be available.
So if we don’t have a undefined benefit plan it must be a defined contribution plan. If so, the next question we ask is who funded most of it? The reason why is the IRS treats pension plans that are over 50% funded by the employee as foreign grantor trusts. The problem with this is that foreign grantor trusts can be very time consuming and expensive to properly report. A Form 3520-A is likely required each year, and the penalty for not filing or filing incorrectly can be $10,000 per form per year. Additionally there could also be a Form 3520 requirement, where penalties can be even steeper.
Yet there is an exception that might apply. The 402(b) exception.
The problem is that the default position of the IRS is to reject 402(b) for everything BUT some Australian Superannuations and Singaporean CPFs. The reasoning is more baffling than you could imagine and we will get into that during our full presentation with Strafford. However, it is possible to get 402(b) treatment if your plan is something other than an Australian superannuation fund of Singaporean CPF. And this can save you thousands in tax prep fee alone each year.
So when are you going to be taxed on your foreign defined contribution retirement plan?
- For grantor trusts, you are taxed on the contribution and the growth, but not the distributions.
- For employee trusts, you are taxed on both the contributions and the distributions, that is, in an employee trust you often are allowed to defer taxes.
The foreign earned income exclusion and foreign retirement plans
Employer contributions to retirement plans are not excluded to the the FIE, but they are tax creditable. However, in many jurisdictions, there are no credits to apply.
For more advanced training, click here for our training with Strafford Publications that will be live on Janary 22, 2019. This training will be available on replay.
How to properly report foreign pensions, retirement plans and social security-type benefits.
Things are about to get somewhat confusing. But before that, most foreign retirement plans also need to be declared on a Report of Foreign Bank Account forms, the FBAR. That's right, even though retirement plans aren't bank accounts, the government takes a very expansive view. You could challenge them, of course, but the penalties are severe if you get it wrong.
How the IRS thinks about retirement plans
For U.S. taxation purposes, all retirement plans can be divided into qualified plans and non-qualified plans. These requirements are detailed in 26 U.S. Code § 401. U.S. providers of retirement plans go way out of their way to meet these qualifications because failure is not an option; failure means revocation of the beneficial tax-deferred status of contributions to these plans (you aren't taxed on the income when it is paid to you but instead when it is paid out from the retirement plan). However, because foreign retirement plans providers aren't primarily concerned with US taxation, it is — bad news alert — incredibly unlikely that a foreign retirement plan will meet the § 401 requirements and therefore will be deemed taxable.
Foreign Retirement plans are considered foreign trusts
If a foreign retirement plan isn't considered a retirement plan for tax purposes, then what is it exactly? Well, if you think about a domestic US retirement fund — ask yourself —strip away the tax language, what type of entity is it? It's really a trust. A donor entrusts a sum of money over to someone to invest it for them in a plan. So the same logic applies to foreign retirement plans. Underneath any labels, they are trusts at heart.
Therefore, foreign retirement plans, as non-qualified plans, are treated as trusts, and the next step is to determine what type of trust it is.
Is your foreign retirement plan a grantor trust or an employees' trust?
There are two types of these trusts, grantor trusts and employees' trusts. In grantor trusts, the invested amounts are considered income when initially paid to the employee, and all gains within the trust are taxed as income when they occur (i.e. when shares are sold or when interest is paid).
Employees' trusts can be treated in a few different ways depending on factors that we will discuss later, but the important detail now is to determine whether the retirement plan is an employees' trust. The crucial detail in making this determination will be the percentage of contributions to the trust that were made by the employer and the percentage that were made by the employee. If the employer has made more than or equal to half of the contributions to the retirement plan, the whole plan is an employees' trust. If the employee has made more than half of these contributions — get ready for it — the trust will have to be bifurcated into two trusts for U.S. tax purposes. In this case, the employer's contributions and the employee's contributions, up to the amount contributed by the employer, will be considered an employees’ trust, and any employee contributions beyond this amount will be considered a grantor trust.
If it is an employees' trust is it exempt or non-exempt?
Once you know that it is an employees' trust, you need to determine if it is an exempt or non-exempt trust. This determination turns on the requirements laid out in § 401, but as I said before, foreign retirement plans will almost never be qualified plans. A non-exempt, qualified employees' trust can also be referred to as a 402(b) trust. The outline for the taxation of these trusts can be found in 26 U.S. Code § 402. There is one more question that needs to be addressed in order to determine the tax treatment of a particular trust, and that is determining whether it favors highly compensated employees. "If 1 of the reasons a trust is not exempt from tax under section 501 (a) is the failure of the plan of which it is a part to meet the requirements of section 401 (a)(26) or 410 (b), then a highly compensated employee shall, in lieu of the amount determined under paragraph (1) or (2) include in gross income for the taxable year with or within which the taxable year of the trust ends an amount equal to the vested accrued benefit of such employee."
Below are the tests for 402(b) or 401(a)(26).
The 410(b) test:
(b) Minimum coverage requirements
(1) In general
A trust shall not constitute a qualified trust under section 401 (a) unless such trust is designated by the employer as part of a plan which meets 1 of the following requirements:
(A) The plan benefits at least 70 percent of employees who are not highly compensated employees.
(B) The plan benefits—
(i) a percentage of employees who are not highly compensated employees which is at least 70 percent of
(ii) the percentage of highly compensated employees benefiting under the plan.
(C) The plan meets the requirements of paragraph (2).
The 401(a)(26) test:
(26) Additional participation requirements.—
(A) In general.— In the case of a trust which is a part of a defined benefit plan, such trust shall not constitute a qualified trust under this subsection unless on each day of the plan year such trust benefits at least the lesser of—
(i) 50 employees of the employer, or
(ii) the greater of—
(I) 40 percent of all employees of the employer, or
(II) 2 employees (or if there is only 1 employee, such employee).
Note: Mandatory retirement plans like the Australian superannuation fund and the Indian provident funds (EPF and PPF), will meet these highly compensated tests because these plans include the employees who are not highly compensated.
Tax treatment of Foreign Retirement Plans
Now that we've covered how to determine what type of trust/foreign retirement plan we are dealing with, we can move on to how to treat each of these plans.
If it is a grantor trust, all contributions to this trust must be included in the income of the employee when these contributions are made (this includes both employer and employee contributions to the plan), and all gains within the plan will be included in income in the years that they occur. The owner of a grantor trust is treated as the owner of all of the property that is owned by the trust and will be responsible for filing 3520s and 3520-As (provided the trust fails to file these 3520-A's which they never file) to report ownership of, transfers to, and distributions from the trust. Owners of these trusts will also be responsible for filing forms 8621 for all foreign mutual funds owned by the trust unless protected from this burden by a provision of the tax treaty that the U.S. has with that country.
Non-exempt employees' trusts that fail to meet the tests determining if the plan favors highly compensated employees will be taxed similarly to grantor trusts. Contributions will be included and the yearly income of the trust will be treated as though it were part of the yearly income of the employee. The primary difference being that ownership of these trusts will not need to be reported on forms 3520 and 3520-A as employees are not treated as the owners of employees’ trusts, and forms 8621 will also not be required for the foreign mutual funds owned by the trust.
Non-exempt employees' trusts that do meet the tests determining if the plan favors highly compensated employees will be taxed a little differently. The employer and employee contributions to these trusts will be included in income when they are contributed, but the income generated within the trust from these contributions will not be included in income until it is distributed to the employee. This is the category that most mandatory retirement plans, like the Australian superannuation fund, fall into. When the funds within these plans are distributed, they will be taxed like an annuity under section 72. This basically means that you will use your contributions (which have already been included in your income and taxed) as a basis in determining how much of a distribution is income. This will work whether you take a lump sum payment, yearly distributions, or distributions structured in any other way.
To summarize, qualified plans are completely tax-deferred and contributions to these plans aren't included in income, maximizing the tax benefits of using this type of plan. Employees' trusts that don't favor highly compensated employees still have some tax benefits, as income generated within these plans is tax-deferred, but contributions to these plans are not tax-deferred. Plans that do favor highly compensated employees and grantor trusts have no tax benefits and are not tax-deferred in any way. Employees' trusts protect employees from having to file forms 3520, 3520-A, and 8621, whereas owners of grantor trusts must file all of these forms unless specifically protected from one or more of these requirements by a tax treaty.
Why you may need to use one of the Voluntary Disclosure Programs
No doubt, this is a topic that is difficult to explain. It is quite reasonable for you to think you did not need to report your foreign retirement fund of an FBAR form (now FinCEN 114) or a 3250, 3250-A. Or have to pay taxes on it. So you may be in non-compliance, and the consequences for non-compliance can be quite harsh. the good news is that we've helped thousands of US taxpayers lower or completely eliminate any offshore penalty exposure.
The new Offshore Voluntary Disclosure Practice ("Son of OVDP" as described by our colleague, Dennis Brager), was announced in November of 2019. Do not assume you need this program. Very few taxpayers actually do. We find 90% of our clients are much better candidates for the streamlined disclosure programs which are much less onerous – all around – than the full OVDP. Our Offshore Disclosure FAQ can answer the most common questions.
This article was last updated Janaury 10, 2019