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October 28, 2013 - Phil Hodgen

Chapter 6 – Taxation of Specified Tax-Deferred Accounts

These special tax-deferred accounts (think “IRAs”) are treated as if they are fully distributed to you on the day before expatriation.  No exemptions.  No exclusions.

Bad news.  But it is bad news for Covered Expatriates only.  Someone who is merely an Expatriate is not concerned with this.

Section 1.  What Are They?

The mark-to-market rule does not apply to everything. A few items are excluded. Among the excluded items are “specified tax deferred accounts.”

The mark-to-market rules do not apply to certain types of tax-deferred accounts. These are the IRAs and other statutorily-created tax-favored accounts found in the Code.

People who are not “Covered Expatriates” do not experience this “make believe” distribution and acceleration of the time of taxation of the IRA.

Summary

Let’s first talk about the specific accounts that are covered by this exception to the mark-to-market rules. A “specified tax deferred account” is defined as:

  • An individual retirement plan as defined in Section 7701(a)(37), but excluding anything described in Section 408(k) or Section 408(p);
  • A qualified tuition program established under Section 529;
  • A Coverdell education savings account as defined in Section 530;
  • A health savings account as defined in Section 223; and
  • An Archer MSA as defined in Section 220.

We will deal with each of these in turn.

Individual Retirement Account

An Individual Retirement Account (“IRA”) is a “specified tax deferred account.”

Classic IRA

We are going to deal with the first bullet-point. What, exactly, is an “individual retirement plan as defined in Section 7701(a)(37)?” And if we find out that an IRA is included in this definition, will the exclusions of Section 408(k) or Section 408(p) apply?

Start at Section 7701(a)(37). It defines an “individual retirement plan” as:

(A)    an individual retirement account described in section 408(a), and

(B)    an individual retirement annuity described in section 408(b).

The individual retirement account described in Section 408(a) is the classic IRA. But there are other types of accounts that are included in the definition.

Roth IRA

A Roth IRA is treated as a regular IRA, with the exception that you designate it as a Roth IRA when you open it. Since a Roth IRA is an individual retirement account as defined in Section 7701(a)(37), it will be subjected to the exit tax rules of Section 877A(e) which cause a deemed distribution on the day before the expatriation event.

Spousal Rollover IRA

A Spousal Rollover IRA is a normal individual retirement account, except for the method of funding. It, too, will be subjected to the exit tax rules of Section 877A(e).

Spousal IRAs are normal IRAs which are funded by contributions from a nonworking spouse. They are standard IRAs. The expatriation of the owner will trigger taxation under Section 877A(e).

Inherited IRA

An “Inherited IRA” is also subjected to the Section 877A(e) tax rules upon expatriation. An Inherited IRA is a normal IRA, inherited upon the death of the original IRA owner, which is subjected to certain minimum distribution rules.

SEPs, Simplified Retirement Accounts Not Included

However, the definition of an IRA for purposes of the exit tax does not include simplified employee pensions and simplified retirement accounts. These are covered in the “deferred compensation” category of assets for purposes of the exit tax.

Other specified tax deferred accounts

While IRAs will be the most frequently-encountered type of specified tax-deferred account for purposes of the exit tax, others you will find include:

  • Qualified Tuition Program, also known as Section 529 plans;
  • Coverdell Education Savings Account;
  • Health Savings Account; and
  • Archer Medical Savings Accounts.

Section 2.  Paperwork

Covered Expatriate

Mechanically, the Covered Expatriate delivers Form W-8CE to the custodian of the specified tax-deferred account. The time for doing this is the earlier of:

  • The day prior to the first distribution on or after the expatriation date; or
  • 30 days after the Covered Expatriate’s expatriation date.

This notice tells the IRA custodian that you are a Covered Expatriate, and puts the custodian on notice to treat your balance as of the expatriation date as a deemed distribution, and make the necessary adjustments to reporting on future distributions to you. Future Form 1099s will report the taxable and nontaxable portion of distributions to you.

Within 60 days of receiving your Form W-8CE, the custodian will provide the value of the IRA on the specified date—the day before expatriation.

Expatriate

If you are an ordinary Expatriate, you will provide Form W-8BEN to the custodian.  Then the appropriate withholding can occur because there is a payment from the IRA to a nonresident alien taxpayer.

Section 3.  Taxation

The mark-to-market rule does not apply to everything. A few items are excluded. Among the excluded items are “specified tax deferred accounts.”

Full Distribution

The tax treatment of a Covered Expatriate’s specified tax-deferred account is simple: there is a “pretend distribution” of the entire IRA balance to the expatriate on the day before the expatriation.

You determine the taxable amount of the distribution and include it in your taxable income.

No early withdrawal penalty

The early distribution tax of 10% is ordinarily applied to IRA distributions that are made too early is not applied to the “pretend distribution” from an IRA or indeed any specified tax-deferred account.

Treatment of account after expatriation

The “pretend distribution” causes income taxation of the entire balance of your specified tax-deferred account, whether or not you take an actual distribution. So it would be possible for you to pay the exit tax and leave the specified tax-deferred account (let’s say it is an IRA) in place.

When you later receive actual distributions, you are not taxed again on the previously-taxed balance. The amount that you are taxed on under Section 877A(e)(1) is treated as an investment in the account under Section 72. You have “basis” in your account. This is how you get the money tax-free when it is distributed to you later.

You have a choice, therefore. You can immediately liquidate the IRA and move the money outside the United States. It has been fully taxed and there is nothing to stop you.

Or, you can leave the specified tax-deferred account in place after expatriation. If you do so, only the earnings accrued after you expatriate will be taxable in the United States. A single 30% tax will be imposed on distributions of these earnings. Your later withdrawal of the balance taxed at the time of expatriation will not be taxed.

Expatriation