By Anthony Diosdi
We often receive inquiries from non-U.S. citizens that are concerned with the U.S. tax implications of withdrawing money from an Individual Retirement Accounts (“IRA”) or 401(k) plan. Often these individuals are in the U.S. for a temporary work assignment and they are concerned with the U.S. withholding tax of 20% or 30%. They are also concerned about the 10% early withdrawal penalty. This article discusses how non-U.S. citizens may use a tax treaty to eliminate the U.S. tax associated with the withdrawal of funds from an IRA or 401(k) plan.
Taxation of Distributions from IRAs and 401(k) Plans Under U.S. Federal Tax Law
Under the Internal Revenue, any distribution from a qualified plan such as an IRA or 401(k) plan that does not qualify as an eligible rollover-distribution is generally subject to a mandatory 20% income tax withholding. Although IRA and 401(k) plan distributions are subject to a 20% withholding tax, depending on the participant’s marginal tax bracket, the U.S. income tax assessed on the withdrawal could be significantly higher. In addition, Internal Revenue Code Section 72(t) imposes a 10% additional income tax on some distributions to individuals that have not reached the age of 59 ½.
The Effect of Income Tax Treaties
The provisions in the Internal Revenue Code governing distributions from qualified plans such as IRAs and 401(k) plans to participants are clear. However, the Internal Revenue Code is not the only body of law that may be applicable to withdrawals from IRAs and 401(k) plans. The Internal Revenue Code provides that all provisions “shall be applied to any taxpayer [but] with due regard to any treaty obligation of the United States which applies to such taxpayer.” In other words, tax treaties may provide an additional legal forum for the taxation of distributions from qualified plans. In certain cases, non-resident participants of qualified plans can reduce or even eliminate U.S. tax associated with a distribution from an IRA or 401(k) plan.
The Relevance of the OECD in Interpreting Tax Treaties
If both the U.S. and a treaty partner were members of the Organization for Economic Cooperation and Development (“OECD”) when a treaty was drafted, U.S. courts are legally bound to mandatorily refer to OECD commentary, which is published every four years, to interpret terms in that income tax treaty. This means, when a tax treaty is unclear, U.S. courts must interpret the treaty terms under the OECD definitions.
How Does a Tax Treaty Work?
In order for a non-resident to utilize a tax treaty to reduce or eliminate the U.S. tax consequences associated with an IRA or 401(k) plan distribution, the non-resident must reside in one of 58 countries that have an income tax treaty with the United States. For example, let’s assume that Tom is a Italian national that came to the U.S. on an E-3 Visa for a short-term assignment. While working in the U.S., Tom contributed money to an IRA. Tom has returned to Italy and would like to withdraw money from his U.S. based IRA. However, Tom is concerned about the U.S. 20% withholding tax and the 10% early withdrawal penalty.
Since Tom is a citizen of Italy, a country that the U.S. has a bilateral income tax treaty, Tom may utilize the U.S.-Italy tax treaty to avoid the 20% withholding tax and the early withdrawal penalty. This is because under Article 18, Paragraph 1, of the U.S-Italian Income Tax Treaty, “pensions and other similar remuneration paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that State.” The Technical Explanations to the treaty further explain that “paragraph 1 provides that pensions derived and beneficially owned by a resident of one of the Contracting States in consideration of past employment..shall be taxable only in the State [of residency].” This means that under the applicable provisions of the U.S.-Italian tax treaty, the country of residence has the sole taxing rights over pension distributions.
The terms “pensions and other remuneration” is not defined in the U.S.-Italian tax treaty. However, the OECD defines the word “pension” under the ordinary meaning of the word which covers periodic and non-periodic payments. The OECD also provides that a lump-sum payment in lieu of periodic pension payments that is made on or after cessation of employment may fall within the definition of Article 18. See OECD 2014 Commentary, Art 18. Thus, although Article 18 of the U.S.-Italian tax treaty makes a reference to “periodic payments,” the word “periodic” does not preclude Tom from excluding a lump sum IRA distribution from U.S. federal income tax. Even though the OECD or Article 18 of the U.S.-Italian tax treaty does not mention the term IRA, the IRS has clarified that IRAs can be defined as pensions for articles in U.S. income tax treaties. See PLR 200209026. Since Tom is a resident of Italy, he can utilize the U.S.-Italian tax treaty to avoid U.S. federal tax on the distribution from his IRA.
Just because Tom can exclude his IRA distribution from U.S. federal tax does not mean that he does not need to file a U.S. tax return. Tom will need to file a U.S. federal tax return (and potentially a state tax return) and report a treaty-based position by attaching a statement to his tax return by using Form 8833. The U.S. Federal Income Tax Regulations meticulously describe the items to be disclosed on a Form 8833. The disclosure statement typically requires six items.
1. The name and employer identification number of both recipient and payor of the income at issue;
2. The type of treaty benefited item and its amount;
3. The facts and an explanation supporting the return position taken;
4. The specific treaty provisions on which the taxpayer bases his or her claims
5. The Internal Revenue Code provision exempted or reduced; and
6. An explanation of any applicable limitations on benefits provisions.
If you are not a U.S. citizen with a U.S. IRA or 401(k) and expect to depart the United States or have already departed the United States, contact us to discuss your options.
Anthony Diosdi is one of several international tax attorneys at Diosdi Ching & Liu, LLP. As an international tax attorney, Anthony Diosdi provides international tax advice to individual, closely held entities and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.