This is another piece of the rewrite project for The Exit Tax Book
Specified Tax-Deferred Accounts After Expatriation: Generally
Distributions from specified tax-deferred accounts after expatriation are unremarkable: an expatriate (covered or not) is treated like any nonresident alien, and taxed accordingly. The only difference will be for covered expatriates: since they are taxed when they expatriate, they are not taxed a second time when they receive distributions of money that was previously taxed.
This chapter discusses distributions from every type of specified tax-deferred account except IRAs:
- Health Savings Accounts (HSAs);
- Archer Medical Savings Accounts (MSAs);
- Section 529 education savings plans; and
- Coverdell education savings plan.
The tax treatment of IRAs after expatriation is sufficiently complex to be handled in its own section. Retirement plans have additional layers of law applicable to them under U.S. tax law and income tax treaties. The other four types of specified tax-deferred accounts are spared from that complexity.
Taxation of Archer Medical Savings Accounts (MSAs)
Archer Medical Savings Accounts (MSAs) have been superceded by Health Savings Accounts. Employers have not been permitted to establish MSAs after 2003.
Although the exit tax rules mention Archer Medical Savings Accounts, this is a matter of historical curiosity. I would be stunned to see an expatriate with one of these accounts.
We will, therefore, spend our time looking at the after-expatriation tax treatment of Health Savings Accounts (HSAs).
Taxation of Health Savings Accounts (HSAs)
Distributions from HSAs face (theoretically) difficult tax analysis. However, reality intervenes, and I suggest a simple way to deal with these distributions.
How They Work
A Health Savings Account is simple in concept:
- Contributions are excluded from income1;
- Earnings grow tax-free2; and
- Distributions, if made for the right purpose (“qualified medical expenses”)3, are not taxable.
Contributions By Expatriates
An expatriate is unlikely to make contributions to an HSA. Tax-deductible contributions may be made to an HSA by an “eligible individual”.4
Among other things, an eligible individual is someone who is covered by a high deductible health insurance plan.5
An expatriate is exceedingly unlikely to maintain a U.S. health insurance plan, let alone a plan of the type required for HSAs.
We will therefore cheerfully skip over the tax treatment of contributions made to HSAs by or on behalf of expatriates.
Account Earnings Before Distribution
An HSA’s investment earnings are tax-free unless the account ceases to be a Health Savings Account.6
There are a number of technical requirements that must be satisfied for an account to be an HSA,7
but these are tied to the way in which the account is set up, rather than the account owner’s status.
As a result, an HSA will continue to be an HSA even after the account owner’s expatriation, and account earnings will continue to be sheltered from U.S. income tax until distribution, even though the account owner is a nonresident alien.
Distributions for Qualified Medical Expenses
The tax treatment of HSA distributions depends on how the money is spent. The particular individual status of the account holder (resident or nonresident) is irrelevant.
If HSA distributions are used for “qualified medical expenses”, then the distribution is not included in the account owner’s taxable income.8
All Other Distributions
In theory, expatriates can use HSA funds for qualified medical expenses, but in practice this is unlikely. Let’s look at the more likely scenario: the balance of an HSA is simply taken as cash after expatriation.
Distributions from HSAs that are not used for qualified medical expenses will be included in the account owner’s taxable income,9
and a penalty tax is imposed on the distribution as well (with some exceptions).10
An HSA distribution to an expatriate will be taxed according to the rules that apply generally to nonresident aliens. An expatriate, after all, is neither a citizen nor a resident (probably) of the United States for income tax purposes.
Calculating the taxability of a payment to a nonresident is a two-step process. First, we determine whether the payment is from a U.S. source. Only income from U.S. sources will be taxed.
Then, we look at how
the income is taxed. Only U.S. source income is taxed. It is either taxed at a flat 30% rate or at normal graduated income tax rates.
HSA Distributions are U.S. Source Income
When an HSA distribution is made, there are two components that are being paid out: the original contribution amount and investment returns on the account balance.
Although there is no explicit guidance on this point, I believe the prudent conclusion is to treat the HSA distribution as U.S. source income.
The investment returns will be interest, dividends, or capital gain. We need to decide whether these payments are from U.S. sources or not.
It is overwhelmingly likely that the investment returns on your HSA balance will be U.S. source income. In any event, the amounts are so small that we shouldn’t spend too much time analyzing the problem. 🙂
But what about the contributed amounts? When this is paid to you from an HSA, is it paid from a U.S. source?
There is, as near as I can tell, no law on this point.
Logic suggests, however, that distribution of the amounts contributed to the HSA should be U.S. source income. When an employer makes a contribution to an HSA on your behalf, the amount contributed is not treated as taxable income to you.11
In a very real sense the HSA contribution is compensation for services rendered.
When you work in the United States, the income earned is treated as U.S. source income.12
HSA contributions made while you were working in the United States are thus “U.S. source” income at the time of contribution. When you expatriate later and withdraw the funds, the funds will still be U.S. source.13
HSA contributions can also be made directly by the taxpayer, rather than the employer. Again, adjusted gross income is reduced by the amount of the contribution.14
Here, there is no easy analogy to look to. But we should assume that the government will assert that later HSA distributions are U.S. source income to the account owner–hence taxable in the United States. If a tax benefit is granted in earlier years, it is reasonable to expect the government to want to claw that benefit back in later years.
Treat Distributions as Effectively Connected Income
We have decided, through tenuous logic and rigorous application of cost/benefit principles (translation: the amounts are so small that you just pretend the government is entitled to tax it), that HSA distributions are U.S. source income. The next question to be addressed is whether the HSA distribution is taxed:
- At a flat 30% tax rate (on Form 1040NR, Schedule NEC); or
- At graduated income tax rates (on Form 1040NR, Line 21).
For practical reasons, I suggest you treat the entire distribution as taxable at graduated tax rates, reported on Form 1040NR, Line 21.
The Contribution Component
Recall that the distribution of cash to you from your HSA is comprised of two parts: the original contribution amounts, and the investment earnings that accrued on the account balance.
The contributed amount–if contributed by the employer–is income derived from services performed in the United States. This type of income is “effectively connected” income15
taxable at graduated income tax rates.16
Therefore, when the payment is received, the contribution component is reported on Form 1040NR, Line 21. You can see the IRS guiding you in this direction when you complete Form 8889 (see Line 16) to report the taxability of your HSA distribution.
The Investment Return Component
Theoretically, the investment return component of your HSA distribution should be taxed at a flat 30% rate.17
This is consistent with the way that IRA distributions are taxed when received by nonresident aliens.
In practice, however, I suggest that you include the investment component return as part of the overall HSA distribution, and treat it as taxable as effectively connected income.
The reason is entirely pragmatic:
- Form 8889 is used to report the receipt of an HSA distribution, and it has no simple way to dissemble the distribution into its component parts.
- The amount of taxable income that would be earned in an HSA as investment returns is likely to be small. HSA balances are never high. This means that the actual tax liability — no matter how the investment returns are taxed — is likely to be small. If the IRS audits you and changes your tax return, the extra tax, penalties, and interest payable will likely be small.
Penalties on Distributions
There is a penalty imposed on HSA distributions that are not paid out for qualified medical expenses: calculate your tax on the distribution, and add 20%.18
This penalty is unavoidable.
Conclusion on Distributions
Keep it simple. Treat the entire distribution as U.S. source income, effectively connected with the conduct of a U.S. trade or business (your performance of services in the United States). Report the entire distribution on Form 1040NR, Line 21. Calculate the penalty tax as required by Form 8889, and pay it.
Life is too short to get any more complicated than that.
Distributions and Covered Expatriates
Covered expatriates face a slightly different treatment for after-tax distributions.
Since the HSA is treated as a deemed distribution at the time of expatriation, the balance is taxed at that time.19
The early distribution penalty is waived.20
A later distribution of the account balance will not be taxed twice: only the increase in value of the account after expatriation will be treated as a taxable distribution, and the 20% penalty will only be imposed on this extra amount.