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PostedIRAs after expatriation for covered expatriates
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Phil Hodgen
Attorney, Principal
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Hello again from Phil Hodgen.You signed up for my "Expatriation Only" email list. To stop receiving these emails, just click the "unsubscribe" link at the bottom of this email and you will never get another one of these. If you want more of this kind of email from me, sign up for one of my other mailing lists.Every Tuesday I answer a question about expatriation from a list subscriber. I also send other emails on this list from time to time, but only about expatriation-related topics.If you want to ask an expatriation question, hit "reply" and send me an email. :-)
Question
This week's question came from reader Hank, who signed up for the International Tax Lunch mailing list. He suggested a number of topics, one of which was this:- Handling of an IRA still held in United States after becoming non-resident.
Answer
Continuing to leave an IRA in the United States after expatriation is a poor strategy. The IRA is subject to US estate tax, and the income tax consequences can be problematic.A covered expatriate would be wise to cash out an IRA immediately after expatriation.Why? Income tax
Here is how a covered expatriate's IRA will be taxed.Income tax on expatriation-date value
A covered expatriate pays income tax on the value of an IRA at the time of expatriation. The exit tax rules treat a covered expatriate as if there is a full distribution of the entire IRA on the day before expatriation. I.R.C. §877A(e)(1)(A).There is no early distribution tax imposed on this "pretend" distribution. I.R.C. §877A(e)(1)(B).No further income tax on the expatriation-date value
Since the entire value of the IRA has been fully taxed, a covered expatriate can immediately close the IRA and take the expatriation-date value out of the United States without any further tax:- The deemed distribution at the time of expatriation is treated as an "investment in the contract" -- roughly equivalent to the concept of basis in an asset. Notice 2009-85, §6; 2009-2 C.B. 598. The return of this amount to you is not included in gross income. Notice 87-16, 1987-1 C.B. 446.
- There is no early distribution tax. The 10% early distribution tax applies only to amount included in gross income, and the return of investment is not included in gross income. I.R.C. §72(t)(1).
Growth after expatriation: taxed at 30%
If the covered expatriate does not immediately close the IRA, it will continue to be treated as an IRA after expatriation: account growth is not taxed, and tax is imposed when a distribution is made.The covered expatriate who waits until after expatriation to take a distribution from the IRA will have the following tax consequences:- Growth will be taxed as fixed, determinable, annual, or periodic income, at a flat 30%. Rev. Rul. 79-388, 1979-2 C.B. 270; I.R.C. §871(a)(1).
- Every distribution to the covered expatriate is pro-rated between return of investment and growth. I.R.C. §72; Notice 87-16, §III; 1987-1 C.B. 446.
- The IRA administrator withholds 30% of every payment. I.R.C. §1441(a). Since some of the distribution to the covered expatriate is nontaxable (return of investment), this means that too much tax will be withheld.
Possible double taxation
If the covered expatriate lives in a country with an income tax, there may be a double taxation of a later distribution from the IRA. This is because the covered expatriate's home country is:- likely to include the later real IRA distribution in taxable income for home country taxation purposes; and
- likely to deny a foreign tax credit for the earlier U.S. income tax paid on the pretend IRA distribution triggered by the exit tax rules.
Why? Estate tax
A non-U.S. citizen who does not live in the United States (jargon: is not domiciled in the USA) has an estate tax risk only for assets located in the United States (jargon: U.S. situs assets). An IRA falls into this category. This means that the value of an IRA will be subjected to estate tax.A U.S. citizen (or a noncitizen domiciled in the United States) has a large exemption from estate tax and gift tax: the first $5.43 million of wealth will not be taxed, whether it is given away during the individual's lifetime, or left to an heir after death.For a non-U.S. citizen who is not domiciled in the United States, the exempt amount is $60,000.In short, if your IRA (and all of your other U.S. situs assets) exceed $60,000 in value, there will be U.S. estate tax to pay.If you have an IRA worth more than $60,000, you would be a damn fool to leave that IRA in the United States and expose its value to estate tax. We should also not forget the cost and delay from forcing your heirs to prepare and file an estate tax return (Form 706-NA).This factor alone should tell you to close your accounts and move the money out of the United States as soon as possible after you expatriate, even if there is an income tax or early distribution tax cost.When and how
Now that you have decided to close your IRA, you have a question of when to do it: before or after expatriation? A few factors that you should consider:- Would taking out the IRA make me a covered expatriate under the net income tax liability test?
- Is a distribution subject to the early distribution tax?
- How does my country of residence see the IRA and tax a distribution from the IRA?