How Does The US Tax Foreign Retirement?
US taxation regards most retirement plans located or established outside the US depends as trusts. Whether trust treatment is appropriate depends on whether there is a person or entity—separate from the owner—who has control over monies put in or taken out, as well as management of investments (if any) within the plan.
This person, in trust terms, is called a trustee. However, if certain conditions are met, not all plans with a beneficiary may be a trust:
The beneficiary may own the property in their foreign retirement plan.
Additionally, no other person or entity can control that property.
Such financial plans as described above are probably not trusts; in such a case, if any other person or entity holds the property without having control over it, that person or entity is probably a custodian, rather than a trustee.
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If the foreign plan is a trust, there are two Code Sections in the Internal Revenue Code (IRC) – the IRC being the source of most rules used by the US Internal Revenue Service (IRS) – that most foreign plans can be grouped into. These are IRC Section 402(b) and IRC Section 679. At a high level, both code sections have to do with trusts. Section 402(b) has to do with what are called “nonqualifying employee trusts (NQET)”, and Section 679 has to do with “foreign grantor trusts (FGT)”. As part of our foreign retirement services, our first step is to classify the foreign plan.
The classification of the foreign retirement plan as a NQET or FGT determines what tax forms need to be filed. Generally, if the foreign retirement plan is established though an employer, it is a NQET. If the plan is self-managed, it is probably a FGT. Neither of these plan types can defer income, which is a little-known fact among tax professionals – and as a result, income may not be properly reported. As a result, our second step is to calculate the foreign plan reportable income.
While NQET plans do not usually have any special informational tax forms to file, all FGTs must file Form 3520 and typically also Form 3520-A. Unless Form 3520 and Form 3520-A are timely filed, the IRS may assess a penalty of $10,000 USD per unfiled form. However, because these forms are filed only to provide the IRS with information, there is no separate US income tax to pay when these forms are submitted. The Form 3520 shows all contributions made and distributions taken from an FGT retirement plan, as well as all basic identifying information about where the plan is held. The Form 3520-A is filed by a trustee of the plan, but since most foreign plan administrators are not aware of this US tax filing obligation, it usually must be completed by the plan participant. Accordingly, the third step of our services is to identify information filing obligations and complete Forms 3520 and 3520-A if needed.
Foreign retirement plans may also have reportable income, not only in the US, but also in the foreign country where the plans are located. If so, there may be foreign taxes paid on the plan that can be claimed as a credit in the US by filing Form 1116. Filing Form 1116 reduces or eliminates double taxation on foreign income, because foreign tax paid to a foreign government reduces the US income tax liability on the same income, dollar-for-dollar. But first, the type of income must be sorted into categories: either general or passive. Passive income is income from investments, rents, and royalties, whereas general category income comes from activities like employment wages or social security. Our fourth step is to categorize and claim any foreign tax credits on your foreign retirement income.
Finally, there are sometimes rules under income tax treaties between the US and other countries that can help reduce the burden of US tax on foreign retirement (with some countries, such as Canada, having somewhat more favorable treatment than others). The application of these rules is frequently an area of uncertainty, because of the possibility of multiple interpretations, and any benefit claimed under a US income tax treaty must be reported on Form 8833. As our fifth and final step, we examine the availability of tax treaty positions for foreign retirement, discuss the risks and rewards, and disclose on Form 8833.
