Let’s talk about how a covered expatriate’s Roth IRA is taxed at the time of expatriation.
A Roth IRA is treated as if there is a make-believe distribution to a covered expatriate on the day before renouncing U.S. citizenship or abandoning green card status.
Income Taxation of the Distribution
The income tax cost of the make-believe distribution is zero if:
- the Roth IRA has been in place for five taxable years (see the explanation below), and
- the covered expatriate is age 59.5 or older.
If those two conditions are not satisfied, part of the fictional distribution will be taxable.
No Early Distribution Penalty
There will never be an early distribution penalty tax imposed.
Exit Tax Concepts Generally
A covered expatriate is someone who:
- Relinquishes U.S. citizenship or loses green card visa status after having held it a long time (i.e., the person is an “expatriate”); and
- Meets one of three criteria (two financial, one procedural) for being The Type of Person Who Should Be Punished for taking the exit ramp from the U.S. tax system (i.e., the expatriate is “covered” by Internal Revenue Code Section 877A).
Once you have decided you are a covered expatriate, you look at everything you own and compute the tax cost of relinquishing U.S. citizenship or abandoning green card status according to four special rules that apply to:
- Your right to receive distributions from certain types of trusts (i.e,. you are a beneficiary of a trust);1
- Deferred compensation you are entitled to receive (think “pensions”, mostly);2
- Certain types of special tax-favored accounts created by Congress, called “specified tax deferred accounts” (clue: a Roth IRA is one of these things);3 and
- Everything else.4
If you figure out which of the four buckets holds the Roth IRA, you can then figure out how the Roth IRA will be taxed when you expatriate.
A Roth IRA is a Specified Tax Deferred Account
A Roth IRA is a “specified tax deferred account” for exit tax purposes.
A specified tax deferred account is a specific type of tax-flavored account created by Congress and enshrined in the Internal Revenue Code:
For purposes of paragraph (1), the term “specified tax deferred account” means an individual retirement plan (as defined in section 7701 (a)(37)) other than any arrangement described in subsection (k) or (p) of section 408, a qualified tuition program (as defined in section 529), a Coverdell education savings account (as defined in section 530), a health savings account (as defined in section 223), and an Archer MSA (as defined in section 220).5
A Roth IRA falls into the definition of an “individual retirement plan (as defined in [Internal Revenue Code] section 7701(a)(37))”. Here is how it works:
- A “specified tax deferred account” includes “individual retirement plans (as defined in Section 7701(a)(37))”;6
- An “individual retirement plan” includes “individual retirement accounts” defined in Section 408(a);7
- A Roth IRA is individual retirement account as defined in Section 408(a).8
Working backwards up the chain of logic . . . because a Roth IRA is an individual retirement account
, it is an “individual retirement plan
And because a Roth IRA is an individual retirement plan
, it is a specified tax deferred account.
Covered Expatriates and Taxation of Roth IRAs
Now that we know that a Roth IRA is a specified tax deferred account, we can find the tax rule that applies to covered expatriates.
In the case of any interest in a specified tax deferred account held by a covered expatriate on the day before the expatriation date . . . the covered expatriate shall be treated as receiving a distribution of his entire interest in such account on the day before the expatriation date.9
Easy concept: a full distribution of the entire amount in the Roth IRA on the day before the expatriation date.
Is the Make-Believe Distribution a “Qualified Distribution”?
On the day before expatriation, the covered expatriate will still be a U.S. taxpayer. The act of expatriation (relinquishment of citizenship or termination of resident status) has not yet occurred. This means we look at the normal tax rules for Roth IRAs to see how the expatriation-triggered fictional distribution is taxed.
The Roth IRA rules tells us that a “qualified distribution” is not included in gross income.10
This means that if the Roth IRA’s fictional distribution triggered by expatriation will be characterized as a “qualified distribution”, then there will be no U.S. income tax payable because of the expatriation event.
A distribution from a Roth IRA is a “qualified distribution” if two things are true:
- The recipient is at least 59.5 years old; and
- Five tax years must separate the date of contribution of funds to the Roth IRA and the distribution date.
The first one is easy. If you are at least 59.5 years old when you expatriate, you win.
The second rule is harder to understand. You must let at least five taxable years elapse between the time that the first contribution was made to the Roth IRA and the date of the distribution:
A payment or distribution from a Roth IRA shall not be treated as a qualified distribution under subparagraph (A) if such payment or distribution is made within the 5-taxable year period beginning with the first taxable year for which the individual made a contribution to a Roth IRA (or such individual’s spouse made a contribution to a Roth IRA) established for such individual.11
This is typical obtuse tax language. It means that you look at the first contribution you made to the Roth IRA. You make a contribution to a Roth IRA for a particular year. You can make the contribution to a Roth IRA at any time before April 15 of the following year.
You make a $2,000 Roth IRA contribution on April 1, 2011, and designate this as a contribution for the 2010 tax year. You report this Roth IRA contribution on your 2010 income tax return. You make no other Roth IRA contributions.
The first taxable year for determining whether a distribution is a “qualified distribution” is 2010.
We have established 2010 as your first “taxable year”. We know that if a distribution is made in the five tax years starting with the year of contribution.
This means that if you receive a distribution in 2010, 2011, 2012, 2013, or 2014, you will NOT be receiving a “qualified distribution” and the Roth IRA distribution is taxable. (This assumes, of course, that you are 59.5 or older).
If you expatriate in 2017, you will be treated as if you received a full distribution of your Roth IRA in 2017 on the day before your expatriation date. This is beyond the five tax year window, so it will be a “qualified distribution”.
For more information, refer to the Treasury Regulations12
and IRS Publication 590-B
Qualified distributions are not included in your income. This means that the make-believe distribution when you expatriate will not cause any taxable income to you, and therefore you will not pay any income tax on the Roth IRA because of expatriation.
Not a Qualified Distribution
If the fictional distribution caused by expatriation is not
a qualified distribution, then it is a regular distribution and there will be tax to pay.
Generally, a Roth IRA allows value to build up inside tax-free, then gives you tax-free distributions when you take the money out as a qualified distribution.
If you do not receive a qualified distribution, you lose the “tax-free increase in value inside the Roth IRA” treatment. Everything you receive above your Roth IRA contributions will be taxable income.
You contribute $2,000 to a Roth IRA on April 1, 2011 and attribute that contribution to the 2010 tax year.
You expatriate on June 1, 2014, when the Roth IRA is worth $3,500.
The fictional distribution is not a “qualified distribution” because fewer than five full tax years have gone by between the contribution date and the distribution date.
Of the $3,500 distribution amount, you will pay tax on the $1,500 build-up in value, and receive your original $2,000 contribution tax-free.
Again, look at Publication 590 for more information about Roth IRAs and how distributions are taxed.
Early Distribution Tax? Never
Remember where we started? A Roth IRA is just like a regular IRA, except for special stuff listed in Internal Revenue Code Section 408A.13
Since the Roth IRA rules have penalties for early distributions from Roth IRAs, we need to figure out whether the fictional distribution created by expatriation will trigger the early distribution tax.14
Fortunately, the rule is dead simple: no early distribution tax is imposed if there is an expatriation-triggered fictional distribution from a specified tax deferred account, including a Roth IRA.15
This means that whether the Roth IRA distribution is a qualified distribution or not, there will be no early distribution tax.
A covered expatriation should give Form W-8CE to the custodian of his Roth IRA. This should be done within 30 days of his expatriation date.16