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May 12, 2015 - Phil Hodgen

Early distribution penalties, IRAs, and expatriation

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Today’s email is written by Haoshen Zhong of our team, who wrote it, and John Bowlby, who did the quality control.

Question: early distribution penalties

A question came by way of e-mail, asking about what happens to the 10% early distribution penalty on a retirement account if a covered expatriate had paid the exit tax on the account.

I have a question regarding covered expatriates and the 10% early distribution penalty on retirement accounts. I understand that the “pretend” distribution will not trigger the penalty on the date before expatriation on individuals under 59.5. My question is: If said individual, still under 59.5, were to take a distribution after they expatriate would the 10% early distribution penalty apply on the amount that was already taxed under the “pretend” distribution or would we say it was already taxed and no penalty should apply? What about if there were gains in the accounts post expatriation?

We’ll use two examples:

  • A traditional IRA that had a pretend distribution under section 877A(e).
  • A 401(k) for which the covered expatriate forgot to give Form W-8CE within 30 days of expatriating. The 401(k) had a pretend distribution under section 877A(d)(2).

The traditional IRA

A traditional IRA, or an individual retirement account, is established under Internal Revenue Code Section 408(a). Distributions from a traditional IRA are taxed under Section 72. 26 U.S.C. §408(d)(1).

A covered expatriate is treated as receiving a full distribution from an IRA on the day before the expatriation date. 26 U.S.C. §877A(e)(1)(A). As the question noted, no early distribution penalty is imposed because of this deemed distribution. 26 U.S.C. §877A(e)(1)(B).

Section 877A(e)(1)(C) says that after the pretend distribution:

“Appropriate Adjustment”

an “appropriate adjustment shall be made to subsequent distributions from the account to reflect such treatment.” 26 U.S.C. §877A(e)(1)(C).

Notice 2009-85 provides that “appropriate adjustment” means:

In the case of distributions that are taxable under the rules of section 72, the amount that the covered expatriate includes in gross income pursuant to section 877A(e)(1) will be treated as investment in the contract for purposes of section 72.” Notice 2009-85, §6; 2009-2 C.B. 598.

10% of what?

Section 72(t)(1) tells us where the 10% early distribution penalty comes from, and answers the question “10% of what?”:

If any taxpayer receives any amount from a qualified retirement plan (as defined in section 4974(c)), the taxpayer’s tax under this chapter for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income. 26 U.S.C. §72(t)(1).

Looking at section 4974(c)(4), an IRA under section 408(a) is one of the qualified retirement plans. It is subject to section 72(t)(1) penalty.

Note that the 10% penalty applies to “such amount which is includible in gross income”, not necessarily the entire distribution.

Notice 87-16 gives a formula for calculating the amount that is not included in gross income, using post-tax contribution to an IRA as the investment amount:

investment/(balance at the end of the year+distribution+outstanding rollover)*distribution

Example

Let us use this in the following example: A U.S. citizen funds a traditional IRA entirely with pre-tax contributions. On the date of expatriation, he is covered, and the IRA has a balance of $100,000. After expatriating, in year x, he is still under 59.5, and the IRA has a balance of $120,000 at the beginning of the year. He takes a distribution of $12,000 during year x.

The amount not included in gross income is 100,000/(108,000+12,000)*12,000 = 10,000. This leaves an amount included in gross income of $2,000

The early distribution penalty is 10% of the amount included in gross income. It is 0.1 * 2,000 = $200.

A covered expatriate escapes the 10% early distribution penalty on the amount that was treated as distributed from his traditional IRA on the date of expatriation.

401(k), covered expatriate, and late Form W-8CE

A 401(k) is a type of arrangement that meets the requirement of section 401(a), so it is a subset of section 401(a) plans. Anything that applies to a 401(a) plan also applies to a 401(k) plan. A distribution from a section 401(a) plan is taxed under section 72. 26 U.S.C. §402(a).

Why the 401(k) plan is taxed

A covered expatriate would not be ordinarily taxable on the value of the 401(k) plan upon expatriation. A 401(k) plan would ordinarily be an “eligible deferred compensation” item and would be taxed on a “30% of each distribution as it is made” basis. 26 U.S.C. §877A(d)(1)(A).

For the purpose of this email, let us assume that the 401(k) became an ineligible deferred compensation item that was distributed under section 877A(d)(2), because the holder neglected to give Form W-8CE on time. It should be delivered to the plan administrator within 30 days of expatriation. Notice 2009-85, Section 8(D).

“Appropriate adjustment”

Section 877A(d)(2)(C) provides that:

“appropriate adjustments shall be made to subsequent distributions from the plan to reflect such treatment.” 26 U.S.C. §877A(d)(2)(C).

Notice 2009-85 provides that “appropriate adjustment” means:

when the covered expatriate receives distributions, the amount that was includible in his or her gross income under section 877A(d)(2) will be treated as investment in the contract for purposes of section 72 in cases where such section would apply to such amounts. Notice 2009-85, Section 5(D).

10% penalty

Section 72(t)(1) tells us where the 10% early distribution penalty comes from:

If any taxpayer receives any amount from a qualified retirement plan (as defined in section 4974(c)), the taxpayer’s tax under this chapter for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income. 26 U.S.C. §72(t)(1).

Looking at Section 4974(c)(1), a 401(a) plan is one of the qualified retirement plans. It is subject to Section 72(t)(1) penalty.

Note that the 10% penalty applies to “such amount which is includible in gross income”, not the entire distribution.

When you take a distribution before the annuity start date, the distribution is pro-rated between investment and growth. 26 U.S.C. §72(e)(2)(B), (3). A distribution before 59.5 is by definition before the annuity start date, so the covered expatriate simply prorates the distribution.

Example

Let’s use this in the following example:

The employer of a U.S. citizen funds a 401(k) entirely with pre-tax contributions. On the date of expatriation, he is covered, and the 401(k) has a balance of $100,000.

After expatriating, in year x, he is still under 59.5, and the 401(k) has a balance of $120,000 at the beginning of the year. He takes a distribution of $12,000 during year x.

The amount not included in gross income is $100,000/($120,000) * $12,000 = $10,000, and the remaining amount of the distribution **is** included in gross income — $2,000, and the remaining amount is not included in income.

The early distribution penalty is 10% of the amount included in gross income. The penalty is 0.1 * $2,000 = $200.

Conclusion

If a qualified plan or IRA is distributed when a covered expatriate expatriates, then the 10% early distribution penalty does not apply to an amount equal to the amount treated as distributed for exit tax calculations and included in income upon expatriation.

If an early distribution penalty applies, it only applies to the growth in value after expatriation. Each distribution is pro-rated between the amount used in the exit tax calculations and subsequent growth, so the early distribution penalty will .

Disclaimer

You know the story. This is information, not advice. Do not rely on it. Go hire someone to give you advice.

See you next week.

Expatriation