You may think that the retirement rules of the United States tax system are complex. For those who have worked abroad, the tax implications for retirement income can be an even more frustrating maze of regulations and treaty agreements. Anyone receiving a foreign pension or annuity payment must become a specialist, not only in U.S. tax law, but in treaty obligations between the countries involved, as well as tax regulations in the country from which the pension or annuity originates.
If it’s your first year sorting out your tax obligations after working abroad, consider asking for help. Specialists in international tax law and retirement holdings can set you on the right path. This will help you to minimize your tax hit and maximize the amount of money you will receive from your retirement savings.
Foreign Retirement Pensions or Annuities
Retirement income from foreign sources can come from different kinds of accounts:
- A pension plan or annuity directly from a foreign employer
- A trust established for you by a foreign employer
- A payment from a foreign government or one of its agencies (this could include a foreign social security pension)
- Payments from a foreign insurance company
- A foreign trust or other entity designated to pay the annuity
Even if you worked for an American company abroad, you might be getting an annuity payment from a foreign trust because of the complications of funding a pension with foreign income. Funding an individual retirement account (IRA) can sometimes be impossible because most of your income can be excluded from U.S. taxes through the foreign earned income exclusion and the foreign housing exclusion.
- Sorting out retirement benefits after working abroad can be a complex maze that is difficult to navigate.
- Foreign sources of retirement income include pensions, annuities, trusts, and foreign governments.
- Some employers allow workers to set up trusts when IRAs—which are only available for those with earned income in the United States—are not an option when working abroad.
- Renouncing U.S. citizenship is an option when the tax situation becomes too complex.
- Contacting a specialist can help maximize retirement income while minimizing taxes.
Because foreign housing and foreign income exclusions allow Americans working abroad to reduce their earned income to avoid taxation by the U.S., they also often make it difficult to invest using IRAs. To qualify to contribute to an IRA, one must have earned income in the U.S. or income on which U.S. taxes are paid. As a substitute, some U.S.companies set up a foreign trust for their employees working abroad to enable them to save for retirement.
When it comes time to collect foreign pensions or annuities, how they will be taxed depends upon which countries hold the retirement funds and what type of tax treaty is in place between the U.S. and the other countries involved.
Each country has negotiated a different treaty with the U.S. So it can make a lot of sense to work with a tax advisor who is, not only familiar with U.S. tax law, but also with the international treaties and tax laws that will affect the taxes you will need to pay to each country. These treaties often include tax credits and other tools to enable you to minimize the amount of taxes you owe, but it will take some research to be sure that you are filling out tax forms in both the U.S. and any foreign countries correctly to minimize your tax hit.
In many countries, a foreign pension enjoys favorable tax treatment within the country, but generally, it does not even qualify as a qualified retirement plan under the IRS tax code. This means that for corporations and their employees, the contributions are not tax-deductible. Because this tends to be the rule, the payments you receive from your foreign retirement plan are not treated the same as a U.S.-based pension.
In fact, even your contributions to the non-qualified retirement plans are fully taxed as part of your gross income. This means that your foreign pension could actually be taxed twice—once when you contributed the money and again when you collect it during retirement.
Tax treaties with many countries sort out this issue so U.S. federal tax liability can be offset. However, you and your advisor must be aware of the treaties and how to fill out the forms for both the U.S. and the foreign country involved.
If you have pensions from foreign countries where you worked, you can start researching tax treaties between the U.S. and those countries at the U.S. Internal Revenue Service (IRS) website. For some of the major countries, individual IRS publications exist, such as Publication 597—Information on the United States–Canada Income Tax Treaty.
U.S. Reporting Requirements for Investments
In addition to complying with tax rules when receiving foreign pensions or annuities, it is also critical to properly report any holdings in foreign banks or investment companies. The U.S. Foreign Account Tax Compliance Act (FATCA) requires any institution holding more than $10,000 for a U.S. citizen to report account information to the U.S. Treasury Department.
Under this act, U.S. citizens who reside in the U.S. must include any financial assets that exceed $50,000 held at non-U.S. financial institutions on their U.S. tax return. For those who reside outside the U.S., reporting becomes mandatory at $300,000.
This can create another kind of tax problem for U.S. citizens working outside the U.S. because even filling out a form to report assets in non-U.S. financial institutions can increase the likelihood of an IRS audit. If your retirement assets are in a fund that the IRS classifies as a Passive Foreign Investment (PFIC), penalties can be particularly stiff for those who do not file. Capital gains from PFIC accounts are taxed at the highest capital gains rate of 37%. There is no 15% long-term capital gains rate for these foreign holdings.
Investing abroad can also require paying much higher fees for investments than U.S. institutions charge. A study by Harvard Business School found that the average expenses for Swiss mutual funds were 43% higher, U.K. mutual funds were 50% higher, and Canadian mutual funds were 279% higher than for U.S. funds.
U.S. vs. Foreign Retirement Accounts
So is it better to hold your retirement investments in the U.S. or in foreign accounts? That, too, is not an easy question to answer because it depends on where you expect to be during retirement.
If you plan to live outside the U.S. in a country with a stable currency, you are generally better off holding the bulk of your money in that country to avoid another major international investing risk—issues around the value of the currency you use for your daily living expenses. The best way to avoid a currency exchange problem is to hold your investments in the currency that you will need to use the most often in retirement.
Renouncing U.S. Citizenship
Some U.S. citizens are dealing with U.S. tax complications by renouncing their U.S. citizenship. Choosing that route can affect whether you will be able to collect Social Security. When you renounce citizenship, you become a nonresident alien (NRA). Whether or not you can collect Social Security will depend on the US bilateral agreements with the country in which you chose to reside. In many countries, the payments can continue, but in some countries your benefits from Social Security cease. Changing your status to "NRA" can also affect benefits for dependents and survivors.
If you are considering renouncing U.S. citizenship to avoid the foreign-retirement tax maze, think carefully about the effect on Social Security benefits before making that decision.
As a nonresident alien, you also must spend one day in the U.S. every 30 days or less. If you don’t visit monthly, your other option will be to spend 30 consecutive days in the U.S. every six months. If you don’t abide by one of these time frames, then you'll lose your Social Security benefits.
If you’ve worked abroad and built your retirement portfolio outside the U.S., seek professional advice before you start to draw your pension or annuity. This will enable you to maximize your retirement income and minimize your tax bite from both the U.S. and the country (or countries) where your retirement funds are held.