Income Taxation of a Covered Expatriate's 401(k) Plan

This Week's Expatriation Question

This week's question is about 401(k) plans. Specifically, covered expatriate's 401(k) plans It comes from reader M.N., who says:

Hi Phil,

Thanks for your great newsletter.

On the subject of IRAs, one question that comes to mind is whether the same considerations that apply to IRAs also apply to 401(k) plans. I suspect that the answer is “yes”, but the absence of explicit mentioning of 401k's in much of the writing on expatriation -including IRS notices- makes me wonder.

Your Chapter 7 mentions 401(a) and 408(k) plans, but not 401(k) plans. Is that because there is a material difference in how 401(k) plans are being treated?

BTW, I'm a long-term permanent resident with 10+ years of permanent residency and plans to return to my home country ($COUNTRY).

Reader M.N. suggested three different 401(k) topics, but I will only answer one this week: how covered expatriates 401(k) plans are taxed. His other topics are important, and I will deal with them in future weeks: how to deal with the 401(k) plan on the Form 8854 balance sheet, and post-expatriation strategies for dealing with a 401(k).

The TL;DR

If you are a covered expatriate, your 401(k) plan is taxed in one of two ways:

• If you screw up some trivial paperwork, you will pay income tax at the normal income tax rates as if you received the entire balance of your 401(k) plan on the day before you expatriated.
• If you do the paperwork right and on time, 401(k) distributions received after you expatriate will be taxed at a flat 30% rate.

The paperwork you should not screw up is Form W-8CE. You should give this to the 401(k) plan administrator within 30 days of renouncing your U.S. citizenship or abandoning your green card visa. There is no slack in this deadline and no mercy for missing it.

You can stop here if you don't want to read the rest of this 2,273 word email. If you want more detail, let's press on.

401(k) Plan = “Deferred Compensation Item”

A 401(k) plan is a “deferred compensation item”¹ in exit tax jargon.

A deferred compensation item is any kind of plan described in Internal Revenue Code Section 219(g)(5).² If you look at Section 219(g)(5), it says that this includes a plan with a trust described in Section 401(a).³

Your 401(k)⁴ plan has that necessary Section 401(a) element in it.⁵ So, following the chain from Section 401(k) to Section 401(a) to Section 219(g)(5) to Section 877A(d)(4), we finally figure out that your 401(k) plan is a deferred compensation item for expatriation purposes.

“Eligible” vs “Ineligible” Deferred Compensation Items

How your 401(k) plan is taxed will depend on whether it is an eligible deferred compensation item or an ineligible deferred compensation item. An ineligible deferred compensation item is anything that is not an eligible deferred compensation item.

The easiest way to understand the difference is to understand the Prime Directive of the IRS: collect money, by force if necessary. An eligible deferred compensation item is one where the U.S. government can easily collect tax. As a result, the tax rules that apply to you are (relatively) benign: you pay tax as you get distributions

Conversely, if it is is difficult or impossible for the IRS to collect tax by force, the deferred compensation item is “ineligible”. The tax rules are simple: pay all your tax immediately when you expatriate, because the IRS isn't sure they will ever be able to collect from you after you leave.

There are three things that must be true for your 401(k) plan to be an eligible deferred compensation item:

• the 401(k) plan administrator who makes the payment to you is in the United States or is a foreigner who elects to be a U.S. person for limited tax purposes;⁶
• you notify the 401(k) plan administrator that you are a covered expatriate;⁷ and
• you waive the benefits of any U.S. income tax treaty that would reduce your U.S. income tax rate below the default 30%.⁸

Break one or more of those requirements and your 401(k) plan is an ineligible deferred compensation item. You pay a giant lump sum tax when you expatriate.

The Hidden Tripwire: Form W-8CE

A 401(k) plan by its nature is an eligible deferred compensation plan. But there is one thing that you must do, and if you do not do this one thing, you will accidentally and irrevocably convert your 401(k) plan from an eligible deferred compensation item into an ineligible deferred compensation item.

What to do: file Form W-8CE with your pension plan administrator within 30 days of your expatriation date.

This is the requirement that you notify the plan administrator for your 401(k) plan that you are a covered expatriate.⁹ As I said, this is logical. The 401(k) plan administrator needs to know that 30% tax should be withheld from future distributions to you, so requiring you to notify the plan administrator makes sense.

What does not make sense is the time frame for doing this.

The form you use to tell the plan administrator is Form W-8CE, and it must be filed within 30 days of your expatriation date:

A covered expatriate who has a deferred compensation item … must file Form W-8CE with the relevant payor on the earlier of (1) the day prior to the first distribution on or after the expatriation date or (2) 30 days after the covered expatriate's expatriation date as defined in section 877A(g)(3)).¹⁰

The first deadline means that a 401(k) distribution occurs within 30 days of the expatriation date. This is never the case in the real world. So it is the second deadline–you must give Form W-8CE to the plan administrator within 30 days of your expatriation date–that is the earlier of the two.

There is nothing in the law or the current IRS procedures that cuts you any slack. If you miss the deadline, you must pay the lump sum tax.

I would expect the timing rule to be relaxed when the IRS writes Regulations interpreting the exit tax rules. Until then, your best bet is to be alert, know your paperwork requirements, and file the right stuff at the right time.

Many, many times we are contacted by people to assist with tax planning (“how can I pay less tax?”) or tax reporting (“what paperwork do I file and can you help me?”) months after they relinquish citizenship or abandon their green cards. By then it is too late. If the individual is a covered expatriate, they have blown the deadline for notifying the 401(k) plan administrator with Form W-8CE. They have created a giant lump sum income tax on the 401(k) plan.

Lump Sum Taxation

If you have an IRA, you (the covered expatriate) are treated as if you received a full distribution of the IRA's value on the day before expatriation.How much was there? That's what you're taxed on.

For a 401(k) plan, however, the amount of the lump sum distribution to you is not simple. The amount you are treated as receiving on the day before expatriation is defined in a complicated way:

With respect to any ineligible deferred compensation item described in section 5.B (1) a, 5.B (1) b, and 5.B (1) c of this notice, an amount equal to the present value of the covered expatriate's accrued benefit is treated as having been received by the covered expatriate on the day before the expatriation date as a distribution under the plan and must be included on the covered expatriate's Form 1040 (or other schedule, as provided in Treas. Reg. § 1.6012-1(b)(2)(ii)(b)) for the portion of the taxable year that includes the day before the expatriation date.¹¹

This sounds like a mess, but it is actually easier than it appears.¹² For some types of deferred compensation plans, you simply use the account balance:

In the case of a defined contribution plan described in section 5.B (1) a, until further guidance is issued, the present value of the covered expatriate's accrued benefit is the account balance.¹³

A 401(k) plan is a “defined contribution plan described in section 5.B(1) a”.¹⁴

The upshot is that you have a rather simple calculation. If you mess up and do not give Form W-8CE to the 401(k) plan administrator within 30 days of your expatriation date, you will be treated as receiving a lump sum distribution of the entire 401(k) plan balance on the day before your expatriation date. You will pay income tax on that amount.

Conclusion: You Are In Control

You, dear covered expatriate, are in control of the situation. If you give your 401(k) plan administrator Form W-8CE within 30 days of your expatriation date, you will pay U.S. income tax on the distributions you receive only when you receive the distributions, and the tax rate will be 30%. You will not be permitted to reduce your U.S. income tax rate by invoking protections from an income tax treaty.

If you do not give your 401(k) plan administration a Form W-8CE within 30 days of your expatriation date, you will be treated as receiving a lump sum distribution of the entire 401(k) balance on the day before your expatriation date, and you will pay U.S. income tax on that amount at the tax rate that applies to you in the year of expatriation. (That rate will probably be higher than 30%, by the way.)

Routine Disclaimer

What would life be like if we didn't have disclaimers? Here you go–a bright, shiny, sparkly disclaimer just for you!

I am not your lawyer and this is not legal or tax advice to you. Blindly relying on an every-Tuesday email you get from some guy who writes something while streaming the Play It Loud 054 Podcast by Sascha Cawa from Soundcloud … just don't do that, OK? Go get specific legal and tax advice before you take action. Tax errors are expensive.

Teaser

I am rewriting and expanding my Exit Tax Book. There will be a student edition and a teacher's edition. The table of contents for the in-depth version is complete and I am writing the zero draft right now. These emails are part of the raw material for the teacher's edition.

I am thinking about an experiment: write the first draft online.

Next Week

Next week I will answer another question about expatriation. Send me an email and sign up for the online workshop to get all of your questions answered.

Phil