That's a difficult question. It's an important question, but a difficult one. Much like peeling an onion, what you see on the surface isn't always what you get. Just when you think you have things all figured out, you realize that there's another layer hiding under the one you just peeled away. And then another, and another after that, and then twenty more for effect.
Next thing you know you're crying. Now it sounds like taxes; it's not dealing with the IRS until there are tears involved.
The point is that it's not as simple as saying "Yes, your foreign retirement plan is taxable" or "No, you're in the clear." More often than not, it's more a matter of when the taxes are going to hit.
Two types of trusts
We'll touch on a few aspects of what makes a foreign retirement plan taxable, but it's important that we start with clarifying the difference between a grantor trust and an employee's trust (because foreign retirement plans are considered to be foreign trusts):
- Grantor trust – The person who's granting the money to the trust becomes the grantor of the trust; for instance, if you transfer your assets to a foreign trust, you're going to be designated as the grantor.
- Employee's trust – You have a trust set up through your employer; an employee's trust requires that you make 50% or less of the total contributions and your employer adds 50% or more.
Now there's a big difference between these two – when you are taxed. For a grantor trust, you're taxed as you make your contributions. This means that by putting money in this type of trust, you're going to be taxed from day one. However, and this is absolutely necessary to understand, the taxes on an employee's trust are deferred to distribution. This means that you won't pay taxes on the trust until you start taking money out.
Let's take a closer look at employees' trusts for a moment as they sometimes turn around and bite unsuspecting taxpayers. We'll say that you work for a company for a period of time and amass $5,000 in contributions to your foreign retirement fund. You then leave that job and take a new position elsewhere, but you decide to continue to contribute to your original trust on your own. As soon as you put in $5,001, you need to now split that into two separate trusts as it's no longer an employee's trust (you've exceeded the 50% contribution limit and shifted from an employee's trust to a grantor trust). Not only will this duplicate your reporting (which is a huge burden), but it also changes the taxation schedule!
Remember that with a grantor trust you're going to be taxed on the income year over year, where as with an employee's trust you can defer taxation until distribution.
Another layer – tax treaties
If you pack up and move elsewhere in the world, it's possible that you may move from a country that has a tax treaty with the U.S. to one that doesn't (treaties are complicated, so we simplified them in a recent podcast). Even if the employer is offering the same deferral in the plan, you may be making contributions that you think are tax deferred but are — in reality — no longer covered by the treaty you previously enjoyed. As a rule, contributions to employee trusts (non-grantor trusts) are included in your income when they’re made so those contributions are not tax deferred. This leads to an ultimate taxation when you take the distributions in the form of an annuity under code section 72.
So, you get basis in as much as you have been taxed on the contributions already, and then the inside gains you defer until distribution. You are paying taxes on your contributions; it's not going to grow tax free like, say, a Roth or a life insurance would, but at least it isn't going to be taxed again when you take it out.
Bear in mind that this creates a ton of incredibly onerous accounting and compliance work. Unfortunately, a foreign retirement plan doesn't generate any kind of report for the IRS; there's no 1098 or 1099 with all the filled-in information ready to be plugged into your tax return.
Compliance work and reporting
There are two forms that need to be completed when we talk about foreign trusts:
- Form 3520 is the Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts
- Form 3520-A is the Annual Information Return of Foreign Trust with a US Owner
Legally, it's the trust that's responsible for completing the 3520-A, however, foreign trusts aren't likely to fill it out and file it with the IRS, shifting the burden to the grantor. If you have a grantor trust, you need to complete Forms 3520 and 3520-A every year (again, technically the trust would be responsible for doing the 3520-A, but that's just not going to happen). Also, make a note that the 3520-A has a different deadline than your 1040 – according to the IRS, it's the "15th day of the 3rd month after the end of the trust's tax year."
If you have an employee's trust, you are not required to file these forms every year; instead, you're only going to file Form 3520 upon distribution. Too many people assume that they don't have to worry about taxation on their foreign retirement plans. If you do not file the forms correctly, the penalties can add up fast, sometimes with disastrous consequences.
Due to the incredibly time-consuming and complex nature of foreign retirement plans, compliance costs can be hefty. It might be well worth the time to consider investing the money in something more along the lines of a post-tax life insurance plan or something similar. Saving yourself the headache of staying in constant compliance (especially with a grantor's trust) can be worth its weight in gold.
We've only just begun
Foreign retirement plans are — without a shadow of doubt — one of the most complicated forms of tax reporting; the amount of compliance work needed is up there with a multi-million dollar offshore company, even though it could be something as simple as a $10,000 retirement plan. What you aren't fairly warned of is the reality that you have to do all of the accounting and create balance sheets and separate income statements for the trust.
When we review the returns brought to us by clients, we find that the majority of them are done incorrectly (even when done by professionals). Even though it's no fault of the client, non-compliance happens quite often; it's important to remember that once you sign a tax document, you are then liable for it (even if it was prepared by a professional). Unless there was open fraud on the part of the preparer, you're the one that's going to be held responsible.
If you are concerned about compliance, now is the time to act; the statute of assessments is open forever, so there's no option to let the clock run out. There are some disclosure programs where you will pay less on penalties and you only have to go back and amend three years of tax returns. If you're overseas, the program has no offshore penalty, but we don't know how long that will last. Take advantage of this as soon as you can!