How are Foreign Pension Payments Paid on Retirement Taxed in the US

Arin V., EA , MBA

Arin is an Enrolled Agent (EA), authorized to represent taxpayers in front of the IRS, and holds a BA and MBA (Management) degree from California State University, Northridge.

From a young age, we keep hearing about the fact that saving for one’s retirement is important. And indeed, many Americans do save and invest for their retirement, whether through an IRA, 401(k), or some other retirement plan. Additionally, for Americans who live overseas, or for non-Americans who immigrate to the U.S., a foreign pension plan might provide an additional way to save for one’s retirement. While diversification is crucial when investing, and the array of investments overseas may prove too interesting (and lucrative) to ignore, in certain scenarios, owning a foreign pension plan can have dramatic tax implications for U.S. taxpayers. 

Perhaps the best way to understand the taxation around foreign pensions is to explain how qualified retirement plans are treated in the U.S. In the U.S. there are three components of a qualified retirement plan, such as a 401(k) plan or Traditional IRA: contributions; accumulated earnings; and distributed benefits. Contributions to these qualified plans are not taxed in the U.S. Further, the annual earnings derived by a qualified retirement plan in the U.S. are not taxable until the taxpayer attains retirement age. Finally, the contributions and accumulated earnings referred to above become wholly taxable when a taxpayer is in constructive receipt of their benefits. A taxpayer will be in constructive receipt of their benefits upon attainment of retirement age or upon some other event (such as disability or death). These benefits will be taxed at this time at the relevant federal, state and city (where applicable) marginal income tax rates.

Therefore, while many U.S. taxpayers are used to receiving a tax deduction for retirement plan contributions (such as through a traditional IRA), receiving tax-deferred growth on their retirement plan (such as through a 401(k)), or receiving tax-free distributions upon retirement (such as through a Roth IRA), no such benefits exist for most foreign pension plans, mainly because the IRS does not consider most of these foreign pensions to be qualified and therefore, contributions to foreign pensions are generally not tax-deductible, there is typically no concept of tax-deferred growth (unless specifically stated by a tax treaty, which we will discuss later on), and distributions upon retirement are taxed in the U.S. Additionally, employer contributions to foreign pensions are generally taxable to U.S. taxpayers.

To make matters worse, you may be subject to tax on foreign pension plan distributions in a foreign country, as well as in the U.S. However, in this scenario, one may be able to take a foreign tax credit on their U.S. tax return to avoid being taxed twice. In addition, if the foreign country you hold the pension plan in has a tax treaty with the United States, you may be able to cite the tax treaty to ensure that the growth within the foreign pension is not taxable in the U.S. However, please note that to ensure that certain phases of your foreign pension plan are not taxable in the U.S., you will have to take a tax treaty position and cite portions of a tax treaty that the U.S. has with the foreign country. If the U.S. does not have a tax treaty with the country in which you hold the foreign pension, you will be unable to take tax treaty benefits, unfortunately.

However, as with nearly everything in life, there are exceptions to these regulations. In certain scenarios, Americans who are resident in a foreign country can obtain favorable tax treatment in the U.S. for contributions made to a foreign pension plan. In spite of that, however, tax treaties are not the holy grail. Why? Because if you are a U.S. citizen or resident, you will also need to consider the so-called “saving clause” (typically found in Article 1 of the tax treaty). The saving clause states that the U.S. has the right to tax its citizens and residents on their worldwide income, as provided under U.S. law, as if there were no tax treaty. If there is no exception to the saving clause for the relevant pension article and paragraph in a given tax treaty, then as a U.S. citizen or resident, your distribution would be taxable in the United States.

To further complicate matters, depending upon the type of foreign pension plan that you have, you will not only need to report the distributions from the retirement plan, but you will likely have to report your foreign pension plan on Form FinCEN 114 (FBAR) and Form 8938. Additionally, you may have to report your foreign pension on Form 8621 if the pension plan qualifies as a passive foreign investment company (PFIC), or Forms 3520/3520A if the foreign pension is held in a foreign trust. 

Therefore, if you have a foreign pension plan, or are considering starting one, please contact us today to ensure that you have the proper tax planning around this very complicated structure, and also, that you are reporting your foreign pension plan correctly, as failure to file the proper forms can result in tens of thousands of dollars in penalties for noncompliance, not to mention penalties for not reporting income.