American citizens living abroad often participate in foreign pension plans, which generally have beneficial tax treatment under local country of residence law. Furthermore, participation might even be mandatory and employers often make valuable pension contributions on behalf of their employees. However, even in light of all these benefits, American taxpayers must remain aware that not all foreign pension plans receive favorable tax treatment under U.S. tax laws and that participation could actually be detrimental to long-term financial planning goals.
In order to avoid 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. Foreign pensions are an area that American taxpayers can no longer ignore as the Foreign Account Tax Compliance Act (FATCA) and increased cross-border tax compliance suggests that 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 demonstrates how to integrate foreign pension plans into a comprehensive cross-border retirement plan.
U.S. Taxpayers and Foreign Pension Plans
Many countries allow workers to defer pre-tax dollars into retirement accounts that then accumulate tax free until retirement. These systems of tax deferred savings and investment exist everywhere for the same reasons they exist in the United States: governments want to encourage 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:
- Swiss Pillar Pension System
- Canadian RRSPs
- Hong Kong Mandatory Provident Fund (MPF) and Occupational Retirement Schemes Ordinance (ORSO)
- Singapore Central Provident Fund (CPF)
- Australian Superannuation
- French Caisses de Retraites
- UK Employer Sponsored Pension Schemes and SIPPs
Unfortunately, the U.S. worldwide system of citizen-based taxation was instituted before modern pension plans and long before the advent of an internationally mobile work force. Consequently, current U.S. tax laws do not favor participation in most foreign pension plans and the IRS generally views foreign pension plans, including ones “qualified” under local tax rules, as “nonqualified” under U.S. tax rules.
However, there are some U.S. income tax treaties which allow foreign pension plans to be treated as qualified for U.S. tax purposes. One such example is the United States-United Kingdom income tax treaty. Unlike many tax treaties the United States has with foreign countries, the U.S.-UK treaty addresses pensions comprehensively, with rules related to contributions, earnings, and distributions. For example, while living in London, an American can deduct, for U.S. tax purposes, contributions to their UK pension plan. This deduction is only available while the U.S. taxpayer resides in the United Kingdom. Additionally, it applies only to the extent the contributions or benefits qualify for tax relief under HMRC (UK tax authority) rules and the HMRC relief may not exceed the relief that is allowed in the United States under IRS regulations.
Outside of the United Kingdom, these special tax treaty provisions are rare: Most foreign pensions do not enjoy tax favored status. For example, the United States does not have tax treaties covering pension contributions with many popular expat destinations such as France, the Netherlands, Hong Kong, and Singapore. Absent such a comprehensive tax treaty, an American expat participating in a foreign pension plan cannot 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 the FATCA law is that U.S. taxpayers participating in foreign pension plans can no longer casually fail to report their participation in these plans on their U.S. tax returns. Before FATCA, participation by American expat workers in foreign pension plans often drew them into a pattern of systematic non-compliance—many investors did not even think 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 to be reported and taxed to an extent that was not possible before FATCA.
Luckily, FATCA regulations contain several provisions designed to exempt certain foreign retirement and pensions funds from FATCA reporting. This means the pension account holders’ identities will not be automatically reported to the IRS. However, this does NOT mean that Americans with foreign pensions can ignore these assets when filing a U.S. tax return. It is essential that U.S. taxpayers take proactive steps to report foreign pension assets on their yearly tax returns to avoid IRS penalties and fines.
To complicate this problem, reporting a foreign pension properly on a U.S. tax return is a time consuming and expensive accounting task. 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 does not 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. Proper compliance is complicated by the lack of information from the foreign pension plan sponsor and uncertainty regarding the best reporting methods among tax preparers.
There is also significant uncertainty amongst tax experts on the application of U.S. tax rules and tax treaties to such nonqualified plans. However, several broad generalizations can be made about foreign pension tax compliance. The taxpayer generally must include the amount of vested pension contributions made by the employer and the employee in their gross income. They may also be required to include in gross income the investment earnings on plan assets even if unrealized. Depending on the country and method used, taxes might need to be paid upon final distribution from the pension plan.
Sidebar: Malta Pensions and “Offshore Pensions Schemes” for American Citizens
Increasingly, American expats in locales such as Singapore, Hong Kong, and Dubai are being marketed offshore pension schemes based in the Mediterranean island nation of Malta. Many offshore financial advisors promote these plans as a tax efficient way for American expats to save for retirement while working abroad. Although it is true that the United States and Malta recently signed a modern double tax treaty that provides certain tax benefits, it is doubtful that the generous interpretation of these tax provisions offered by plan promoters will hold up under eventual IRS scrutiny. Therefore, we believe that Americans investing in such schemes are taking on substantial tax compliance and investment risk.
The U.S.-Malta double taxation treaty signed in 2010 created a flurry of activity in the U.S. expat finance space because key provisions of the treaty appear to permit American taxpayers to accumulate untaxed gains in a Malta pension and then withdraw those assets tax free. There are several problems with this attractive reading of the treaty. It is unlikely that the treaty was intended to provide for a glaring exception to the main tenants of U.S. citizenship based taxation. Even more critically, these plans gloss over the issues of residency and jurisdiction. The treaty does not cover Americans who are not resident in Malta, or at least not resident in Malta at the time that contributions to the plan were made. Americans outside of Malta have no standing to make claims under the treaty’s provisions.
Aside from the tax and compliance risk posed by these plans, the investment provisions of these plans are highly unattractive. In general, most of the Malta pension plans require a large ongoing financial commitment. Liquidity is low, fees are high, and the underlying investments are opaque. There is concern over the regulatory and financial capacity of the small state of Malta to thoroughly ensure the integrity and solvency of these offshore pension plans.
Incorporating Foreign Pensions into a Comprehensive Retirement Plan
The absence of treaty protection and lack of tax qualified status does not automatically make participation in a foreign pension plan a bad idea. Several strategies can be used to make investments within pension plans U.S. tax compliant and efficient. Whatever reporting method used, it is essential to keep the tax treatment consistent between different filing years. Using different methods to file and report the pension year-to-year creates a risk that double taxation may occur.
If an American investor resides in a country with income tax rates that are higher than corresponding U.S. rates, excess foreign tax credits are likely to accrue. If no treaty provision exists to provide a U.S. tax deduction for local pension contributions, contributions will only reduce local country current taxation. However, because there are still sufficient foreign tax credits available to offset all 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 a part of normal pension distributions will therefore be tax free for U.S. purposes. 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 has the virtue of using up foreign tax credits (which otherwise may never be used) and reducing the level of U.S. taxation on future distributions. Even where net U.S. and local taxation of pension plans is unfavorable, generous 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 account. However, this is never possible with any type of foreign retirement account. A much more common scenario is that the foreign country will allow an expat to withdraw funds when they permanently leave the country. The ability to withdraw funds from a local plan is very country specific. This option must be examined under local country of residence law with the assistance of a local legal/tax expert.
What to do with Foreign Pensions?
FATCA is essentially forcing the IRS to confront the fact that the U.S. system of global taxation is inconsistent with normal participation in traditional methods of retirement and investing for American workers abroad. However, because these problems with FATCA have not yet been resolved, US taxpayers don’t have the option of ignoring foreign pensions. American expatriates need to become familiar with the relevant tax laws that effect their foreign pensions. Given the potential tax exposure and large penalties, it is important to plan ahead to understand the tax treatment of these pension plans and their tax reporting requirements. In order to avoid future problems, Americans living abroad should also be aware of the tax treatment of contributions to and distributions from these foreign plans—taxation of distributions must be minimized, fees reduced, and the investment options of the pension plan must be analyzed.
After a careful analysis, it might not be efficient for an American abroad to participate in a foreign pension plan or for them to simply maximize their contributions. Careful asset allocation across different accounts such as a taxable brokerage, 401k, IRA, Roth IRA, and a foreign pension is essential to achieve tax efficiency and maximum after-tax returns for successful retirement saving and greater overall wealth accumulation. Ultimately, most Americans abroad will find that U.S. onshore investments, managed with an eye on tax efficiency and cross-border tax compliance are the best way to build wealth.
For more information, consult our Guide on Investing and Financial Planning for Americans Living Abroad.