Hello again from Phil Hodgen.
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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.
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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:
This week, we will look at what happens to an IRA after its owner expatriates. In order to keep this email relatively short, I will only talk about covered expatriates.
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.
Here is how a covered expatriate’s IRA will be taxed.
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).
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:
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:
Treaties may or may not alleviate the problem. A number of income tax treaties give the United States the right to tax former citizens for a period of time after expatriation. The effectiveness of these treaty clauses is unknown (they were written to apply the now-extinct rules of I.R.C. §877) but the fact is that these provisions exist, creating problems.
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:
Foreign tax credit is usually given only when there is a taxable transaction. The change in U.S. tax status from resident to nonresident is simply not a taxable transaction as far as the home country is concerned.
What this means is that the United States will tax the value of the IRA when the IRA owner expatriates, but the covered expatriate’s home country will not tax it — because it is not a real IRA distribution and thus is not taxable under home country tax laws.
And it means that the United States will not tax the later distribution of funds from the IRA (because under U.S. law the money was already taxed) but the home country will tax the later distribution.
Foreign tax credits are built to solve problems like this, but from the home country’s perspective, the exit tax paid to the United States will look like a noncreditable foreign income tax — something that the home country will not let the covered expatriate carry forward to later years when the actual distribution occurs.
This is a murky, murky area at the moment. Foreign countries are just now starting to come to grips with the problem of how to deal with the U.S. exit tax. The results here can vary depending on the application of income tax treaties. So the moral of the story is to tread carefully.
The better solution for a covered expatriate is to close out the IRA and distribute everything shortly after expatriation. In that way, the U.S. tax on the pretend distribution and the home country tax on the real distribution will happen in the same year. You can likely claim the foreign tax credit because these events happened so close in time. Not that we are suggesting anything but full and utter fealty and unwaivering faithfulness to your home country tax law. Far from it.
Or, if the covered expatriate is over 59.5 years old, simply take a real distribution from the IRA before expatriation. There will be no early distribution penalty, and the distribution is classically taxable in the USA and foreign tax credits can be taken in the home country.
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.
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:
This is a one-at-a-time analysis. No hard and fast rules apply, but generally I suggest that covered expatriates close out their IRAs before expatriation (if they can avoid the early distribution tax) or immediately afterward (if they cannot avoid the early distribution tax).
Your mileage may vary, this is not advice to you personally, everyone is a special snowflake and your life is different so get competent tax advice from someone. Look before you leap.
Thanks to Haoshen Zhong for a lot of help this week in getting this email out. I have lots of family stuff happening this week (one kids moving up from middle school to high school, and another graduating from high school).