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IRA Distributions for Noncovered Expatriates
Many people have Individual Retirement Accounts when they expatriate. This time, I will talk about how to handle IRA distributions after expatriation – for noncovered expatriates. The prompt came from reader LC, who emailed me a question. Lightly edited (to hide personally-identifiable facts), this is what LC sent me:
I currently live in [country with no income tax and no income tax treaty with the USA]. I expatriated in 2014. I am not a covered expatriate. My IRA was included on my 8854 submitted for the 2014 tax year. My income in the USA consists of Social Security and the minimum required distribution from my IRA. I plan to “finally retire” in either Northern Europe or Canada in about 3 years.
My tax consultant advises that I receive the income (SS plus IRA distribution) payable in full into my US bank account and pay quarterly estimated taxes via “Form 1040-ES (NR)”. Subsequently, I should then file a 1040NR tax return each year.
Is this a expensive exercise designed to keep my tax consultant employed? [LOL.] Would I be better off paying the 30% withholding tax to the IRA custodian and to Social Security and never filing a US tax return again? If I cash the IRA would I be subjected to some enormous tax? Am I required to file a US NR tax return forever?
Lots of questions, LC! I am going to skip over the Social Security questions and only focus on the IRA distributions you are receiving.
The method you are using for the tax liability is wrong, even though you end up paying the correct amount of tax. Your IRA plan custodian should be withholding 30% of every distribution you receive, and sending it to the IRS. You should not be paying quarterly tax to the IRS on the distributions you received.
To do. Give Form W-8BEN to the IRA plan custodian. It will start withholding 30% on every distribution made to you.
Your actual tax liability to the USA is complicated to calculate. Right now you may be paying more or less tax than you should – this depends on the tax bracket you are in. And your real U.S. tax liability might be more or less than the 30% withholding that is imposed.
Filing a tax return
You are required to file a tax return to report the IRA distributions.
Let’s go back to First Principles and figure this out.
What is the taxpayer?
The first thing we do is figure out whether the taxpayer is a “resident alien” or “nonresident alien”. We know (because LC told us) that he is a nonresident alien in the eyes of the U.S. tax system.
We also know that LC is not a “covered expatriate” because he told us so, and this means we can avoid complexities that arise from that.1
This tells us tax rules apply
The U.S. has two different sets of income tax rules – one for residents and citizens, and another for nonresident aliens.
Since LC is a nonresident and noncitizen of the United States, he falls into the latter category. We will figure out how LC is taxed and what tax returns he must file, based on his nonresident alien status.
These tax rules basically2 say that a nonresident alien (like LC) will only be subjected to U.S. income tax for income from “U.S. sources” and will not be taxed on income from “foreign sources”. The income will either be taxed at the regular tax rates that apply to U.S. citizens and residents, or at a flat 30%. Exceptions exist, of course. The biggest exception is that these rules can be subject to override by an income tax treaty.
What is the source of income?
To figure out LC’s tax liability from the IRA distributions he receives every year, we first figure out whether the Internal Revenue Code thinks the IRA distributions are “U.S. source” or “foreign source” income.
Distributions from an IRA are “U.S. source” or “foreign source”. Here is how you figure it out.
The money in an IRA comes from two components. One is the contributions: what you put into the IRA every year. The other is the earnings: after you made a contribution, the investments created capital gain, dividends and interest.
You contribute $2,000 to an IRA. The money is invested in a mutual fund. One year later, the value of the IRA is $2,200. We allocate $2,000 of the total IRA value to the contribution you made, and $200 to the earnings generated by the investment in the mutual fund.
The glory of the Internal Revenue Code is such that we must separate out these two elements, and do separate tax calculations on each. We must analyze each component for “source of income” purposes.
The source of income from working (“personal services” as tax law calls it) is where you are on Planet Earth when you do the work. If you are in the United States when you do the work, the income is U.S. source.3
Let’s assume LC was living in the United States when he worked and contributed to his IRA. This means that the contributions he made to the IRA came from U.S. source income. And if the contributions to the IRA were from U.S. source income, then the IRA distributions attributable to those contributions will be treated as U.S. source income.4
Turning now to the earnings component of the IRA distribution – the income generated on investments. This is treated as U.S. source income, too.5 The reason is that income was generated from assets located in the United States.
In summary, we have a simple solution: the entire IRA distribution is treated as U.S. source income.
How is the distribution taxed?
Remember that every IRA distribution has two components. This means that you will be taxing each component differently. Each piece goes to a different part of Form 1040NR, and each piece has a different tax rate.
A nonresident alien can be taxed by the United States in one of two ways:
- If the U.S. source income received by that person is passive in nature (interest, dividends, etc.), the tax rate is 30%.6
- If the U.S. source income received by the nonresident alien is active in nature (“effectively connected with the conduct of a U.S. trade or business”, to use the tax vernacular), then the income is taxed at the normal tax rates – the more money you receive, the higher the tax rate.7
Original Contribution: Regular Tax Rates
The part of your IRA distribution that can be traced to the original IRA contribution made will be taxed as “effectively connected income”, at regular tax rates. The original income received from services rendered in the United States was “effectively connected income” because the work was done in the United States. That made the income taxable at regular graduated tax rates. Instead of taking it as income then, you parked some of it in an IRA and reduced your income by that amount, gaining a tax benefit. You deferred the tax on the IRA contribution amount.
Later, like LC, when you take the distribution from your IRA, you are no longer living in the United States or working in the United States. You are not engaged in business in the United States (where your “business” is the business of working for an employer).
No matter. You look at the income to determine its character and taxation based on the year it was earned, not the year it was received. This means that when the IRA distributes money to you, it is treated as income effectively connected with the conduct of a trade or business, up to the amount of your contributions to the IRA.8 It is taxed at normal graduated income tax rates.9
Investment Earnings: 30%
The part of your IRA distribution that can be taxed to the investment earnings will be taxed as passive income from U.S. sources, at a flat 30% tax rate.10
You contribute $2,000 to an IRA while you are living and working in the United States. The money is invested in a mutual fund. One year later, the value of the IRA is $2,200. We allocate $2,000 of the total IRA value to the contribution you made, and $200 to the earnings generated by the investment in the mutual fund.
You expatriate as a noncovered expatriate. Then you take a full distribution of all of the assets of the IRA. You receive $2,200.
Of the distribution, $2,000 is attributed to your original IRA contribution. It is taxed at normal graduated income tax rates. Helpful foreshadowing: this goes on Form 1040NR, Line 16a and 16b.
The $200 of the distribution is taxed at a flat 30% tax rate. Helpful foreshadowing: this goes on Form 1040NR, Schedule NEC, Line 8, column ©. You’re welcome.
Filing a tax return
Fun stuff. You get a payment from the IRA custodian for a distribution from your IRA, and you have to break it into two pieces to figure out how much tax you pay.
Next, the tax return.
Yes, you must file a tax return if you are receiving an IRA distribution as a noncovered expatriate nonresident alien. If you have income from U.S. sources that is taxable for any reason in the United States, you must file an income tax return.11
You report the two parts of the IRA distribution on Form 1040NR. As noted above in the example, the portion of the distribution that is traced to the original contributions will be reported on Form 1040NR, page 1, on Line 16 (as effectively connected income) and the portion of the distribution that is traced to investment earnings will be reported on Form 1040NR, Schedule NEC, Line 8, column ©.
The withholding tax will be reported on Form 1040NR, Line 62b (if the plan custodian issued a Form 1099 to you because you did not announce your nonresident alien status) or Line 62d (if you gave the plan custodian a Form W-8BEN).
What’s Left Unsaid: Treaties and Strategy
I haven’t dealt with the question of income tax treaties. When LC retires, he will live in a country that has an income tax treaty with the United States. Treaties usually say “the country of residence gets to tax the IRA distribution, not the country of source.” This is a way to eliminate U.S. income tax on an IRA distribution, but of course the country of residence will impose income tax – at perhaps a tax rate higher than the U.S. rate.
This relates to LC’s question about pulling all of the money out of the IRA, and whether it is a good idea. If he does that now, he will only pay U.S. income tax on the distribution. If he does it when he retires to Canada/Europe, he will only pay the country of residence income tax on the distribution. Which is better? Who knows! Math being your friend, LC should look at the amount of money involved, compute the tax at U.S. rates and the rates for his selected country, and the low-tax number wins.
And of course once he has emptied out his IRA he need not ever file a U.S. tax return again.
Yet another baroque disclaimer for you. I’m not LC’s lawyer, and I’m not yours. Go do your own homework or hire someone to help you, please. Don’t rely on a newsletter to make big life decisions! Especially not mine.
See you in a couple of weeks.
- IRC §877A(e) has a special rule that forces a covered expatriate to pretend that he/she received a full distribution of an IRA on the day before expatriation. Since LC is not a covered expatriate, we do not need to worry about the implications of that rule. ↩
- I use the weasel-word “basically” because tax law is riddled with exceptions to almost every rule. Do you see what I did there? Even my “weasel-word disclaimer” has a weaselly disclaimer of its own. ↩
- IRC §861(a)(3). ↩
- Rev. Rul. 56-125, 1956-1 C.B. 627. ↩
- Rev. Rul. 79-388, 1979-2 C.B. 270. ↩
- IRC §871(a). ↩
- IRC §871(b). ↩
- IRC §864©(6). ↩
- IRC §871(b). ↩
- IRC §871(a). ↩
- Regs. §1.6012-1(b)(1)(i). ↩