In my last blog post I discussed how Australia taxes distributions from US retirement accounts. But that’s only half of the picture because the US may also tax these distributions. For US citizens, the US tax treatment is clear and well known. But, what if you’re not a US citizen (or green card holder) when you withdraw your US retirement savings?
These issues were the subject of a series of three podcasts I recorded with John Richardson last week (links below). The purpose of this post is to summarise the key points covered in those podcasts.
The US tax code starts off with the presumption that everyone is a potential US taxpayer, subject to US tax on their worldwide income, then carves out special rules for nonresident aliens who are taxed only on US source income.
So, who is a nonresident alien (NRA)? There are two parts to the definition, and you must meet both to avoid US taxation on your non-US income. The first part is nonresident – that is, you must not live in the US. The US tax code has a residence test that is based on physical presence – the “substantial presence test” – where you add up your days in the US in the current year plus 1/3 of your days in the US the immediately prior year and 1/6 of your days in the US in the year before that. If the total is 183 or more, then you’re a resident (there are exceptions and treaty tiebreakers, but that’s beyond the scope of this post). You’re also a resident if you are a lawful permanent resident of the US (green card holder). The second part of “nonresident alien” is that you must be an alien, which is a legal way of saying that you’re not a US citizen. So, nonresident aliens are the vast majority of individuals on the planet. If you’ve renounced US citizenship, or if you worked in the US for a while on a non-immigrant visa before moving back home, then you’re probably an NRA. If you also accumulated savings in an IRA or 401k, then you need to understand how the US will tax distributions from those accounts to an NRA.
Don’t forget that your home country may also tax these distributions, so be sure you understand both sides of the equation.
Two types of income
If you’re an NRA, then the US will tax only your US-source income. This will include dividends from US companies, rental income from US properties, income from a US-based business, salary and wages earned while working in the US. The Internal Revenue Code divides this into two basic types of income: Effectively Connected Income (ECI), and everything else (called Fixed, Determinable, Annual or Periodic (FDAP) income).
ECI is essentially US business income, including employment income. If a business has an effective connection to the US – premises in the US, sales contracts signed or negotiated in the US, etc. – then that income is taxable in the US. When an individual earns ECI, they will pay US tax by completing a Form 1040NR. ECI is taxed net of any allocable expenses and progressive tax rates will apply. Often there is no withholding tax on ECI, but if tax is withheld any excess withholding can be claimed as a refund on Form 1040NR.
No deductions are allowed to reduce FDAP, the gross receipts are fully taxable, generally at a flat tax rate of 30%. This rate may be reduced by treaty – the IRS provides a list of withholding rates by country on its website. If you qualify for a lower withholding rate, use form W8-BEN to inform the payer of the correct rate. Form W8-BEN doesn’t go to the IRS – it goes into the records of the payer. The basic idea is to get the withholding right so that no US tax return is required. However, if too much tax is withheld, a refund can be requested by filing Form 1040NR.
It’s important to note that the withholding provisions, while coordinated with the tax rates, are not in the same parts of the Internal Revenue Code as the provisions that determine whether income is ECI or FDAP or what rate of tax applies. This will result in withholding on certain types of ECI, which is often higher than the actual tax computed on form 1040NR.
What type of income is a retirement account distribution?
Once you are no longer a US resident, the US tax on your 401k or IRA distribution will depend on whether that distribution is ECI or FDAP and on whether the distribution is covered by the relevant tax treaty.
Absent treaty benefits, the first question is whether the 401k or IRA represents “deferred compensation”. This will depend on how the funds entered the US retirement savings system – if the money came from employer contributions (including salary sacrifice contributions), then it will be deferred compensation. Almost all 401k (and 403b) accounts are funded this way. IRAs can be created either by making tax deductible contributions directly or by transferring funds from a 401k or other employer scheme. Direct contributions are probably not deferred compensation. Why all this focus on deferred compensation? Because §864(c)(6) says that deferred compensation is ECI as long as the services that gave rise to the deferred compensation would have been ECI at the time the services were performed. That is, if the deferred compensation is from services performed inside the US, then that deferred compensation is ECI and you can file form 1040NR to apply progressive tax rates. On the other hand, if the source of the money that funded the account is not from employment inside the US, the distribution is not ECI, and will be taxed under the rules for FDAP, which, absent a treaty benefit, will mean a flat 30% tax rate.
What if a treaty applies?
Tax treaties provide a complex overlay to the Internal Revenue Code. Each treaty is different, so be sure to get advice from a professional who is experienced in working with the treaty that applies to you (generally the treaty between the US and the country where you live). Most treaties have an article that covers pensions and annuities, and the majority of these provide that pensions and annuities paid to NRAs living in those countries will not be taxed by the US (but will be taxed by the resident country). To qualify as a pension subject to the treaty, payments generally have to be made due to retirement (see, for example, page 53 of the IRS technical explanation to the 1996 model treaty), so early withdrawals may not qualify for exemption or reduction of US tax under the treaty. Under the Australia-US tax treaty, for example, the country you live in has the sole right to tax pension payments. Therefore, Australian-resident NRAs receiving post-retirement income from a 401k or IRA, will pay zero US tax on these distributions. This treatment is the same whether the distribution is ECI or FDAP.
Some countries have US tax treaties that place a cap on the tax rate the US can collect on pension payments. In these countries the ECI vs FDAP distinction is relevant. If the distribution is ECI, then US tax is computed at progressive rates, but capped. If the distribution is FDAP, then the US tax will be a flat tax at the treaty rate.
US Tax withholding
When you receive a distribution from your IRA or 401k, the plan administrator may withhold US taxes. The amount of withholding is a separate issue to the actual US tax liability (you will be able to get a refund of any excess withholding by filing form 1040NR). The plan administrator is required by §1441 of the Internal Revenue Code to withhold 30% from payments to foreign addresses unless a withholding exemption or reduced rate of withholding has been documented (some plan administrators may just withhold the full 30% and let the recipient deal with applying for a refund). If you live in a country with at tax treaty that provides for a lower rate of tax on US-source pensions and annuities, then you may be able to claim a lower rate of withholding by providing the payer with Form W8-BEN (US Persons would use form W9 to claim exemption from withholding under §1441, which applies only to non-resident aliens). For FDAP income, a properly prepared Form W8-BEN is supposed to set the withholding rate to the actual US tax rate so that you are not required to file Form 1040NR.
Summing it all up…
If your 401k or IRA withdrawals are exempt from US tax under a relevant tax treaty, you should ensure that the payer is aware of this exemption by giving them a completed Form W8-BEN. Your US tax on the distribution will be zero and you can claim back any excess withholding on Form 1040NR.
If no treaty applies (or the relevant treaty provides for a maximum rate below 30%), then you’ll need to determine whether your distribution constitutes deferred compensation. Deferred compensation is ECI, subject to progressive tax rates, while FDAP is subject to a flat rate of 30% (possibly reduced by treaty). Any excess US tax withheld can be claimed by filing Form 1040NR.
As I mentioned up front, John Richardson and I did a series of three podcasts on the US taxation of NRAs. Here are the links: