American workers are constantly fed the mantra of retirement savings: “Max out your 401k or IRA contributions.” Tax deferral and company matches make this generally sound advice. For Americans abroad, however, this simple equation often leads to disastrous U.S. tax complications when applied to foreign pension plans.
America’s system of citizenship-based taxation usually doesn’t treat favorably standard employer pension plans in most foreign countries. So Americans abroad must tread very carefully when it comes to deciding whether or not to participate in these plans. Below are the six most important questions every American expat must be able to answer in order to make effective decisions about participating in a pension plan while residing abroad.
Does the U.S. have a double tax treaty with my country of residence that covers pensions?
The U.S. has double tax treaties with more than 70 countries. Some of these treaties provide comprehensive agreements to mutually “qualify” the other country’s system of employer-sponsored pension plans. That is, each government respects the tax benefits and structure of the other country’s plans. Modern tax treaties with countries such as Canada, the U.K. and Germany fully qualify the other country’s employer-pension system. Therefore, participation by Americans is generally tax-wise and not excessively complicated. With other countries (e.g. Spain, or France, or Australia), older tax treaties provide limited agreement concerning how to treat pension plans in the other country. In these countries, Americans participating in local plans will need very sophisticated tax advice regarding how to report their local pension plan on a U.S. tax return. In countries without treaties (for example, Hong Kong, Brazil, Singapore) voluntary participation in local pension plans is ill-advised. The U.S. will not recognize the pension as qualified, and participation often triggers complex U.S. reporting requirements and punitive tax rates.
Will the local tax benefits of participation simply result in a bigger U.S. tax bill?
In some cases (Spain and Switzerland, for example), local income tax rates can be lower than U.S. tax rates. In these cases, contributing to a locally qualified pension reduces local taxable income and lowers the local tax bill. However, reducing the local tax bill will likely reduce the available foreign tax credit and conversely raise the corresponding U.S. tax liability, thereby negating the purpose of participating in a pension plan. This happens when plan contributions cannot be deducted from U.S. taxable income, because there is no treaty clause providing a U.S. tax deduction for local pension contributions. This is one of many ways that a local tax benefit is cancelled out by America’s insistence on citizenship-based taxation.
Will my pension plan be treated as a foreign grantor trust for U.S. tax purposes?
Although this question may sound very technical, it is critical if you choose to roll foreign employer pension assets into a self-directed pension plan (as is common in the U.K. with self-invested pension plans—SIPPs—and in Australia with self-managed superannuation funds) or set up a self-directed pension plan in a country where there is no treaty provision that “qualifies” such plans. Generally, once the employee begins to self-manage pension assets, the plan becomes a “grantor trust” and can trigger nasty U.S. reporting requirements, including filing an annual Foreign Trust Report (IRS Form 3520) and reporting the underlying investments as Passive Foreign Investment Companies (PFICs) on IRS Form 8621. These annual requirements are complex and result in punitive taxation and should be avoided at all costs.
Do Malta pension schemes provide a superior alternative pension platform for Americans abroad?
Malta-based pension plans are widely marketed to Americans as a solution to their foreign pension problems. Plan sponsors claim that the U.S.-Malta Double Taxation Treaty provides unique tax benefits for Americans participating in Malta pension plans. Unfortunately, these claims are untested and are unlikely to survive IRS scrutiny. Most importantly, the treaty only covers Americans residing in Malta making their distribution to Americans globally especially dubious.
Do my U.S. retirement accounts create a local tax reporting problem?
Just as the U.S. may not provide preferred treatment for your country of residence pension plan, your U.S. retirement accounts may be treated punitively in your country of residence. A few countries tax only locally sourced income (Hong Kong, for example), so U.S. retirement accounts are generally not a problem in these countries. Many countries will tax residents on their worldwide income but still recognize the principle of tax deferral within a U.S. qualified plan. A few countries (such as the U.K. or Canada) may treat U.S. plan assets and contributions as qualified, thereby recognizing both the deductibility of contributions and tax deferral on income within the plan.
Are IRA and 401k contributions permitted while I am living abroad?
Generally, IRA (and 401k) contributions by American taxpayers living abroad are allowed by U.S. rules. The catch is, however, that contributions must be made from non-excluded earned income. Therefore, if your foreign wages are below the U.S. Foreign Earned Income Exclusion threshold of $101,300 and you are claiming the exclusion, contributions are not allowed because all income has been excluded. Be careful, however. Contributing to a U.S. pension plan while resident in a high tax country may inadvertently result in double taxation. This happens when no tax benefit accrues from the contribution but distributions during retirement will still be taxed.
Mr. Kuenzi is the Director of International Wealth Management. Prior to joining Creative Planning, he founded Thun Financial Advisors, a leading independent advisory firm serving Americans abroad and investors across the globe.