401K & Expatriation
401K & Expatriation: When it comes to Expatriation from the United States for Covered Expatriates, one of the most important aspects for future tax purposes is what happens to their 401(k). While the 401(k) does not fall into the mark-to-market equation analysis, it is considered a form of deferred compensation — which means it may still be taxable as a “deemed distribution.” But, unlike other deferred compensation — such as foreign pension – the 401(k) is considered eligible deferred compensation — and as long as the Covered Expatriate follows the necessary procedures, the accrued benefits will not be deemed distributed.
Eligible Deferred Compensation
To begin with, only a covered expatriate may even have the headache and the hassle of having to assess whether or not they have any eligible or ineligible deferred compensation at the time of expatriation that qualifies for a possible immediate deemed distribution tax calculation. If you are a non-covered expatriate, it is not an issue.
When it comes to deferred compensation, eligible deferred compensation receives an immediate tax-deferred benefit.
Specifically, instead of the amount of money being deemed distributed at the time of expatriation — as long as the expatriate follows the rules — then the tax consequences do not occur until the time the distributions commence. And, when distributions are made, the withholding is at 30%.
This is where the problem begins.
26 U.S.C. 877A
This is the code section that deals with the taxation rules at expatriation.
(3) Eligible Deferred Compensation Items
For purposes of this subsection, the term “eligible deferred compensation item” means any deferred compensation item with respect to which—
(A) the payor of such item is —
(i) a United States person, or
(ii) a person who is not a United States person but who elects to be treated as a United States person for purposes of paragraph (1) and meets such requirements as the Secretary may provide to ensure that the payor will meet the requirements of paragraph (1), and
(B) the covered expatriate—
(i) notifies the payor of his status as a covered expatriate, and
(ii) makes an irrevocable waiver of any right to claim any reduction under any treaty with the United States in withholding on such item.
It is very important that the code section indicates that the covered expatriate is not entitled to make a claim to reduce the withholding of tax. Therefore, the 401K administrator will withhold 30% from each payment to the covered expatriate.
This is further clarified in Notice 2009-85 (below).
(2) Eligible deferred compensation item means any deferred compensation item with respect to which:
(i) the payor is either a U.S. person or a non-U.S. person who elects to be treated as a U.S. person for purposes of section 877A(d)(1) and (ii) the covered expatriate notifies the payor of his or her status as a covered expatriate and irrevocably waives any right to claim any withholding reduction under any treaty with the United States.
See section 8 of this notice for the applicable filing and reporting requirements. Separate guidance will be issued under section 877A(d)(3)(A) providing rules for a non-U.S. person to elect to be treated as a U.S. person for purposes of section 877A(d)(1).
Initial waiver of treaty benefits for eligible deferred compensation items and annual reporting requirements. A covered expatriate who wishes to treat a deferred compensation item as an eligible deferred compensation item must make an irrevocable election on Form 8854 for the taxable year that includes the day before the expatriation date to waive any right to claim any withholding reduction under any treaty with the United States with respect to the eligible deferred compensation item.
See section 5.B(2) of this notice. The covered expatriate must make a separate election for each deferred compensation item that he or she wishes to treat as an eligible deferred compensation item.
The covered expatriate must also annually file Form 8854 to certify that no distributions have been received from his or her eligible deferred compensation item(s) or to report the distributions received.
Notice 2009-85 Example
The notice 2009-85 provides a baseline summary of how the taxation rules work involving expatriation. When it comes to eligible deferred compensation, the notice provides the following example:
- Example 17
F relinquishes his citizenship on November 11, 2009, and becomes a covered expatriate. On November 10, 2009, the day before F’s relinquishment of citizenship, F was a participant in a plan described in section 401(a) that includes a trust exempt from tax under section 501(a)
F complies with the procedures prescribed in section 8 of this notice for notifying the payor of his status as a covered expatriate and making an irrevocable waiver of any right to claim treaty benefits with respect to withholding on the payment.
Therefore, F’s interest in the plan is an eligible deferred compensation item and tax will not be due under section 877A until F receives taxable payments from the plan. When F receives taxable payments from the plan, the payor will be required to withhold 30 percent of the gross amount of each taxable payment pursuant to section 877A(d)(1).
Filing Form W-8CE
In order to comply with the procedures in Section 8, the taxpayer covered expatriate will file a form W-8CE within 30 days of expatriation.
Withholding vs Tax Treaty Refund under 1040-NR
While the IRS is steadfast about the 30% withholding — the withholding rate is not the same as tax rate. There is a school of thought that a treaty country covered expatriate can file an annual 1040-NR to claim a refund based on the difference of the treaty tax rate and withholding.
An example of a tax rate treaty reduction clause:
Nothing in this Agreement shall be construed so as to preclude either Contracting State from applying any withholding tax system according to its domestic laws.
However, if the Agreement provides for an exemption from or a reduction of tax, the amount withheld in excess of the limitations prescribed by the Agreement shall be refunded upon request of the taxpayer entitled to the relief in question.
Covered Expatriates Must Maneuver About the US Tax Matrix
In conclusion, when a taxpayer is a covered expatriate and still has 401K, it is important that they properly update their administrator to make sure it qualifies as eligible and not ineligible deferred compensation.
Interested in Expatriation from the U.S.?
Our firm specializes exclusively in international tax.
Contact our firm today for assistance with getting compliant.