American expatriates frequently engage in foreign pension plans, which generally receive favorable tax treatment under the laws of their host country. In some instances, involvement in these plans is mandatory, with employers also offering substantial pension contributions on behalf of their employees. Despite these compelling incentives, American taxpayers must recognize not all foreign pension plans receive favorable tax treatment under U.S. tax laws. Consequently, enrolling in such plans might inadvertently undermine the pursuit of their long-term financial planning goals.
To avoid potential retirement planning pitfalls, U.S. taxpayers with overseas pensions must carefully examine their pension plans under relevant U.S. tax laws and bilateral tax treaties. The realm of foreign pensions has transformed into an area that American taxpayers can no longer ignore. The Foreign Account Tax Compliance Act (FATCA) and ever increasing cross-border tax compliance signal the IRS may take a closer look at these assets going forward (especially so-called “offshore pension schemes”). This Creative Planning International article briefly summarizes common issues related to foreign pension plans and outlines strategies to integrate these plans into a comprehensive cross-border retirement strategy.
U.S. Taxpayers and Foreign Pension Plans
Many countries allow workers to defer pre-tax income into retirement accounts that then accumulate tax-deferred until retirement. These systems of tax-deferred savings and investment exist everywhere for the same reasons they do in the United States: governments want to incentivize workers to accumulate private savings to support retirement expenditures without exclusive reliance on state pension systems.
Foreign pension plans commonly encountered by Americans abroad include:
- Australian superannuation system
- Canadian registered retirement savings plans (RRSPs)
- French Plan d’épargne retraite (PER)
- Hong Kong Mandatory Provident Fund (MPF) and Occupational Retirement Schemes Ordinance (ORSO)
- Swiss three-pillar pension system
- U.K. workplace pensions and self-invested personal pensions (SIPPs)
Unfortunately, the U.S. citizenship-based taxation system was established before modern pension plans and long before the advent of an internationally mobile workforce. Consequently, existing U.S. tax laws don’t support participation in most foreign pension plans, leading the IRS to generally categorize foreign pension plans, including ones deemed “qualified” under local tax laws, as “nonqualified” under U.S. tax rules.
However, certain U.S. income tax treaties do recognize foreign pension plans as qualified for U.S. tax purposes. One such example is the income tax treaty between the United States and the United Kingdom. Unlike many tax treaties the United States concluded with foreign countries, the U.S./U.K. treaty addresses pensions in a comprehensive manner with rules related to contributions, earnings and distributions. For instance, an American citizen living in London can deduct, for U.S. tax purposes, contributions to their U.K. pension plan.
This allowance is limited to the period during which the taxpayer resides in the U.K. and only applies to the extent the contributions or benefits qualify for tax relief under the criteria established by HMRC (the U.K. tax authority). The extent of HMRC relief may not exceed the one permitted in the U.S. under the Internal Revenue Code (IRC). Beyond the United Kingdom, these special tax treaty provisions are rare. Most foreign pensions don’t enjoy a tax-favored treatment. For instance, the United States lacks comprehensive tax treaties covering pension contributions with most popular expat destinations, including the Netherlands, Hong Kong and Singapore. In the absence of such comprehensive tax treaty articles, an American expat participating in a non-U.S. pension plan can’t deduct contributions from their U.S. gross income and must take extra steps to properly report the pension assets.
Staying Compliant: Properly Reporting Foreign Pensions as a U.S. Taxpayer
One important unintended consequence of FATCA is that U.S. taxpayers participating in foreign pension plans can no longer overlook their responsibility to report their involvement in these plans on their U.S. tax returns. Prior to FATCA, participation by American expat workers in foreign pension plans often led them into a pattern of systematic non-compliance, as many investors failed to report these pension plans until retirement distributions commenced. However, FATCA now provides the IRS with a viable mechanism to enforce rules requiring foreign pension plans be reported and taxed to an extent that was previously unattainable.
Fortunately, FATCA contains several provisions designed to exempt certain foreign retirement and pension funds from FATCA reporting. This strategic approach ensures the confidential information of pension account holders remains shielded from automatic disclosure to the IRS. However, this exemption doesn’t grant Americans with foreign pensions the liberty to ignore these assets when filing a U.S. tax return. It remains essential for U.S. taxpayers to proactively report foreign pension assets on their yearly tax returns to avoid IRS penalties and fines.
Adding a layer of complexity to this issue, the proper reporting of a foreign pension on a U.S. tax return is a time consuming and expensive accounting obligation. Participation in a foreign pension will generally require Form 8938, Foreign Bank Account Report (FBAR or FinCen 114), and possibly Form 3520 relating to U.S. owners of foreign trusts. If the pension plan doesn’t meet certain requirements, Form 8621 reporting for passive foreign investment companies (PFICs) may also need to be filed to report underlying investments if the pension is classified as a grantor trust. The need for proper compliance is further amplified by the lack of information from the foreign pension plan sponsor and the uncertainty regarding the best reporting methods among tax preparers.
There’s also significant uncertainty among tax experts regarding the application of U.S. tax laws and tax treaties to such nonqualified plans. Despite this complex landscape, several overarching observations can be made about the tax compliance of non-U.S. pension plans. The taxpayer generally must include the amount of vested pension contributions made by the employer and the employee in their gross income. Additionally, they may be required to incorporate the unrealized investment earnings from plan assets into their gross income. This scenario varies depending on the country and accounting method used, potentially leading to tax liabilities upon the distribution of funds from the pension plan.
Malta Pensions and “Offshore Pensions Schemes” for American Citizens
Certain offshore pension schemes, including those offered by Malta, have often been marketed to American expatriates as alluring tax-saving opportunities. However, these seemingly advantageous strategies can eventually prove too good to be true, leading to adverse consequences for taxpayers. Such loopholes, initially presented as opportunities for legitimate tax optimization, frequently end up being closed by regulatory authorities, leaving taxpayers exposed to substantial tax penalties that can extend back several years.
Every year, the IRS singles out around twelve tax arrangements warranting closer attention from U.S. citizens. Disputes over these arrangements could result in fines, as seen with instances including syndicated conservation easements and Maltese pension plans.
For example, some U.S. taxpayers asserted that Maltese pension plans should be regarded as a Roth IRA under the tax treaty between the United States and Malta. This assertion aimed to enable tax-free asset withdrawals, subject to specific conditions, even with contributions greatly surpassing prescribed Roth IRA limits. The IRS countered this scheme by establishing a joint U.S.-Malta competent authority arrangement (CAA), clarifying that these personal pension plans are not categorized as “pensions” under the tax treaty. As a result, distributions from these plans don’t retain tax-exempt status, unlike Roth IRAs. The IRS has initiated audits for those who used the treaty — especially high-net-worth U.S. taxpayers who invested substantial assets in these plans, some having made tax-exempt pension distributions. In addition, non-compliance with FBAR and FATCA may also add further complexities for some taxpayers.
Ultimately, while offshore pension schemes and complex tax strategies might appear attractive at first, stricter regulations and action from the IRS can lead to serious financial repercussions for taxpayers who relied on these methods for tax reduction. Schemes such as Maltese pension plans gained popularity among wealthy Americans for treaty-related tax benefits. However, these claims have been disproven over time with stringent penalties for those who used them.
Incorporating Foreign Pensions Into a Comprehensive Retirement Plan
The absence of treaty protection and lack of tax qualified status shouldn’t dissuade participation in foreign pension plans. Several strategies can render investments within pension plans compliant and tax-efficient from a U.S. perspective. Regardless of the chosen reporting method, maintaining consistent tax treatment across different filing years is crucial. Discrepancies in filing and reporting methods year to year creates a risk of double taxation.
If an American investor resides in a country with higher income tax rates than those in the U.S., excess foreign tax credits are likely to accrue. If no treaty provision exists to provide a U.S. tax deduction for local pension contributions, these contributions will only reduce the current taxation in the host country. However, due to available foreign tax credits to offset the corresponding U.S. tax on these contributions, contributing to the plan reduces net current taxation. For U.S. tax accounting purposes, the pension plan now has a tax basis equal to the original contribution amounts. In retirement, the return of this basis as part of normal pension distributions may therefore be tax-exempt for U.S. purposes. In cases where no treaty provision exists to qualify the local pension for U.S. tax purposes, optimal planning would require contributions to the local pension in an amount that results in an equalization of the local tax due with U.S. tax, leaving no excess foreign tax credits. This approach capitalizes on using up foreign tax credits which otherwise may never be used, thereby reducing the rates of U.S. taxation on future distributions. Even where net U.S. and local taxation of pension plans is unfavorable, substantial employer contributions and employer tax equalization policies may still make pension plan participation worthwhile for highly compensated U.S. expats.
A common misconception is that funds from a foreign pension plan may be rolled over into a U.S. qualified retirement plan, such as a 401k, IRA or Roth IRA. However, this practice is never possible with any form of non-U.S. retirement account. Instead, expatriates can have the option to withdraw funds when they permanently leave the host country. The ability to withdraw funds from a local plan varies widely between countries and must be examined with the guidance of a local legal or tax expert.
What to Do With Foreign Pensions
FATCA essentially compels the IRS to confront the mismatch between the U.S. global taxation system (with conventional approaches to retirement) and investment for American workers outside the U.S. Yet, due to unresolved issues with FATCA, U.S. taxpayers don’t have the option of ignoring foreign pensions. American expatriates must become familiar with the relevant tax laws that affect their foreign pensions. Given the potential tax liabilities and substantial penalties, it’s important to plan ahead to understand the tax implications and reporting requirements of these pension plans. To circumvent future complications, expats living abroad should also be aware of the tax treatment of contributions to — and distributions from — these foreign plans, aiming to minimize taxation on distributions, lower fees and evaluate investment options within the pension plan.
After careful analysis, it might not be optimal for an American expat to participate in a foreign pension plan or maximize their contributions. Careful asset allocation across different accounts, such as taxable brokerage accounts, 401k plans, IRAs, Roth IRAs and foreign pensions is essential to achieve tax efficiency and optimize after-tax returns for successful retirement saving and greater overall wealth accumulation. Ultimately, most American expatriates will find that U.S. onshore investments managed with a focus on tax efficiency and cross-border tax compliance offer the most effective path to wealth accumulation.
For more information, consult our guide on Investing and Financial Planning for Americans Living Abroad.
