Foreign pension plans present unique challenges for U.S. citizens living overseas because they meet at the intersection of frequency and complexity from a U.S. tax perspective.
Here is how to navigate the complexities of these plans.
Foreign pensions are a very common feature of U.S. expatriate life, but their U.S. tax considerations can vary significantly from plan to plan. For this reason, the plans are one of the most misunderstood and mishandled items on the U.S. federal income tax return.
Although foreign pension plans can take a variety of forms, a typical overseas plan involves a private arrangement that provides for the provision of retirement benefits in connection with employment and allows for the deferral of taxation on plan contributions and earnings in the country where the plan is established. In this sense, foreign pension plans can be distinguished from ordinary deferred-compensation arrangements, which aren't organized primarily for the provision of retirement benefits, and from Social Security arrangements, which are government-managed systems funded by taxpayers.
Although income taxation may be deferred in the country where a foreign pension plan is established, this has no bearing on the U.S. federal tax treatment of the plan. Many U.S. citizens living abroad are unaware of this distinction and mistakenly think that their foreign pensions aren't taxable in the United States because they aren't taxable in their country of residence.
The U.S. Internal Revenue Code and accompanying Treasury regulations have provisions that allow for full U.S. tax deferral of pension plan contributions and earnings until withdrawal upon retirement, but most foreign pension plans don't qualify for this beneficial treatment and therefore trigger tax in the year that contributions are made or earnings are generated. Tax-deferral treatment under the code requires satisfying a number specific conditions that most foreign plans don't take into account, such as requirements on participation, non-discrimination, vesting standards, contribution limits and distribution rules.
An important starting point in analyzing the taxation of a foreign pension plan is determining whether the plan should be classified as a trust for U.S. federal income tax purposes. This is because Section 402(b) of the code provides helpful rules for employees' trusts that don't qualify for full U.S. tax deferral.
In this regard, the Internal Revenue Service has ruled in a number of instances that particular foreign pension plans, including so-called superannuation funds, should be treated as trusts for U.S. tax purposes.
Assuming trust classification, the taxation of employer contributions and earnings will then depend on whether the foreign pension plan is discriminatory. This is determined based on the plan coverage ratio of highly compensated employees to non-highly compensated employees.
Highly compensated employees are defined to include those with certain employer ownership interests or employees who have an annual compensation of $120,000 or more, which is an inflation-adjusted amount for last year.
As a general rule, under Section 402(b), in the case of non-discriminatory pension plans, employees must include employer contributions in income but can defer tax on pension earnings until withdrawal upon retirement.
In the case of discriminatory plans, the highly compensated employees may need to include both contributions and earnings in income. Such employees can at least take solace in the fact that paying tax generally means that they won't have to pay tax on a future withdrawal upon retirement.
A number of additional factors further complicate the above rule, including whether an employee's interest in a pension plan is considered vested for tax purposes, and whether the pension plan is actually funded with employer and/or employee contributions. On top of all this, the general U.S. tax treatment of a pension plan may be overridden by the provisions of a relevant tax treaty that contains a pension provision.
In terms of U.S. tax return compliance, foreign pension plans can potentially trigger the obligation to file a number of international tax forms, including Form 8938 (Statement of Specified Foreign Financial Assets), otherwise known as the FATCA form, and the Report of Foreign Bank and Financial Accounts (the FBAR form).
In the case of foreign pension plans that qualify as employees' trusts, Forms 3520 and 3520-A, which deal with foreign trust reporting, may be triggered if employee contributions to the plan exceed employer contributions. In such cases, the employee is considered the owner of the employee contribution portion of the trust under the grantor trust rules, and the trust is bifurcated into two pieces.
The piece qualifying as a grantor trust has a filing requirement on Forms 3520 and 3520-A and may have additional reporting requirements depending on the pension's underlying investments. If the employer contributions exceed the employee contributions, the entire plan is generally treated as a non-grantor trust that doesn't trigger a 3520 or 3520-A filing obligation.
The complexities of foreign pension plans, both from a substantive tax perspective and a reporting perspective, make U.S. citizens abroad participating in such plans particularly susceptible to tax return omissions and errors that can prove costly if penalties are imposed by the IRS. Given these complexities, it is important to give foreign pension plans their proper analytical due before reporting them to the IRS.