Income and Assets · Retirement income

Foreign pensions and retirement income

The mistake this topic punishes is assuming that a foreign retirement arrangement is the foreign equivalent of a 401(k) and is therefore tax-deferred here. It is not. Qualified status is a creature of IRC § 401(a), and a foreign trust cannot have it. What the United States taxes, and when, is decided by IRC § 402(b) — under which employer contributions are often income to the employee as they vest, years before any money is paid. A treaty may reverse that, and often does; but the treaty is the reason, not the plan’s status abroad.

The rule

Pensions are gross income. IRC § 61(a)(11) puts pensions in gross income by name. Nothing about a foreign arrangement changes that, and the fact that the host country defers or exempts the income has no bearing on the United States charge.

A foreign employer plan is a nonexempt trust. Where a trust is not exempt under § 501(a) — which a foreign trust is not — employer contributions made during a taxable year are included in the employee’s gross income in accordance with § 83, substituting the value of the employee’s interest in the trust for the fair market value of the property (IRC § 402(b)(1)). Section 83 taxes property transferred for services when it is no longer subject to a substantial risk of forfeiture. The consequence is that vesting is the taxing event, and a taxpayer can owe United States tax on an accrual they cannot touch for thirty years.

Distributions are then taxed under § 72. The amount actually distributed or made available is taxable to the distributee in the year distributed or made available, under § 72 — except that income of the trust distributed before the annuity starting date is included without regard to § 72(e)(5) (IRC § 402(b)(2)). Amounts already taxed under paragraph (1) are investment in the contract and are recovered tax-free, which is why the contemporaneous record matters so much.

A highly compensated employee is treated worse. Where one of the reasons the trust is not exempt is a failure to meet § 401(a)(26) or § 410(b), a highly compensated employee includes, in lieu of the ordinary amounts, the whole vested accrued benefit other than investment in the contract, as of the close of the trust’s taxable year (IRC § 402(b)(4)(A)). Non-highly compensated employees are relieved of paragraphs (1) and (2) where the coverage failure is the sole reason (§ 402(b)(4)(B)).

The foreign earned income exclusion does not reach any of this. Foreign earned income does not include amounts received as a pension or annuity, and does not include amounts included in gross income by reason of § 402(b) or § 403(c) (IRC § 911(b)(1)(B)(i), (iii)). Both halves matter: the exclusion shelters neither the eventual pension nor the current inclusion of employer contributions.

Treaties change the answer, on their own terms. The Code is applied with due regard to any treaty obligation of the United States applying to the taxpayer (IRC § 894(a)(1)), and neither a treaty nor a statute has preferential status by reason of being one or the other (§ 7852(d)(1)) — the later in time governs a genuine conflict. Whether a particular arrangement is covered is a question about the text of the particular treaty, and it must be read.

Foreign social security is not social security. A social security benefit for IRC § 86 purposes means a monthly benefit under title II of the Social Security Act or a tier 1 railroad retirement benefit (IRC § 86(d)(1)). A foreign state pension is neither, so none of the § 86 formula applies to it: it is ordinary income in full unless a treaty provides otherwise.

A credit, not an exclusion, is the usual relief from double tax. A citizen or resident may credit income, war profits and excess profits taxes paid or accrued to a foreign country (IRC § 901(b)(1)), subject to the § 904 limitation. The mismatch this topic creates is one of timing: the foreign tax often arrives years after the United States tax.

Three reporting regimes, and they are independent. Specified foreign financial assets above the thresholds are reported under IRC § 6038D, with a penalty under § 6038D(d). A United States person treated as owner of a portion of a foreign trust reports under § 6048(b), with the § 6677(a) penalty. And a foreign financial account is reported to FinCEN under 31 CFR 1010.350(a). The retirement exception in 31 CFR 1010.350(g)(4) covers plans under §§ 401(a), 403(a), 403(b), 408 and 408A — all domestic — so it does not reach a foreign arrangement.

Rev. Proc. 2020-17 relieves one of the three. An eligible individual — broadly, one compliant with their income tax obligations relating to the trust — is exempt from § 6048 reporting for an applicable tax-favored foreign retirement trust meeting six conditions in § 5.03 of the procedure. Section 4 says in terms that the revenue procedure does not affect any reporting obligation under § 6038D or under any other provision of United States law, including the FBAR.

Current figures

How it works in practice

Work the substantive question and the reporting question separately, because the answers do not follow each other. A treaty may make an arrangement tax-deferred and leave every reporting obligation intact; a revenue procedure may relieve one form and leave the tax and the other two untouched.

On the substantive side, the order is: is there a treaty, does it cover this arrangement by its terms, and if not, what does § 402(b) produce. The § 402(b) answer needs the plan’s own records — the value of the employee’s interest, year by year, and what was vested when. Where those records do not exist, and they frequently do not, the fallback is a reconstruction the client will have to stand behind.

On the reporting side, run all three tests every year and note that they use different measures: § 6038D looks at asset values against thresholds that differ for a taxpayer living abroad; the FBAR looks at account balances at any point in the year against a much lower figure; § 6048 asks whether the arrangement is a foreign trust at all. One can be met and another missed in the same year.

Do not overlook the timing mismatch on the credit: where § 402(b) taxes contributions on vesting and the host country taxes the pension on payment, the credit arrives in the wrong year and § 904 may strand it.

How this has changed

Rev. Proc. 2020-17 removed a penalty exposure that had become the dominant risk on this topic. Before it, an ordinary foreign workplace pension could be a foreign trust for United States purposes, and a failure to report it carried the § 6677(a) penalty — the greater of a fixed amount or 35 percent of the gross reportable amount, which on a lifetime pension pot is a very large number for a paperwork failure. The procedure exempts an applicable tax-favored foreign retirement trust and, in section 6, sets out how an eligible individual may seek abatement or refund of penalties already assessed or paid, subject to the § 6402 and § 6511 limitations.

Its conditions are narrow and worth reading against the actual plan. Section 5.03 requires, among other things, that the trust be tax-favoured in its own jurisdiction, that annual information reporting be available to that jurisdiction’s tax authorities, that only contributions with respect to earned income be permitted, that contributions be limited by a percentage of earned income or by the annual or lifetime caps the procedure specifies, and that withdrawals be conditioned on retirement age, disability or death or carry penalties. An arrangement permitting unrestricted contributions or withdrawals does not qualify.

The FBAR due date moved and the regulation did not follow. 31 CFR 1010.306(c) still directs that reports be filed “on or before June 30 of each calendar year”. The IRS states the current rule: the FBAR is due 15 April following the calendar year reported, with an automatic extension to 15 October that need not be requested. Filing on the regulation’s date would be six weeks late even after the extension is counted from the correct one — a rare case where following the published regulation is the error.

Section 6038D is recent enough that older material omits it entirely. It was enacted in 2010 and sits alongside, not instead of, the FBAR. Any checklist that treats the FBAR as the foreign reporting obligation predates it.

Exam focus

Expect the tested point to be when the income arises, not whether. A fact pattern describing employer contributions to a foreign plan and asking what is reported this year is asking about IRC § 402(b)(1) and § 83.

Expect the foreign earned income exclusion offered as a distractor. It is unavailable for pensions and for § 402(b) inclusions alike, by two separate clauses of § 911(b)(1)(B).

Expect the reporting forms to be tested as a set, with relief from one presented as relief from all. Rev. Proc. 2020-17 § 4 is the answer to that.

Watch for a foreign state pension described as “social security”. It is not within IRC § 86, and saying so is usually the whole question.

Check yourself

1. A United States citizen abroad has 9,000 dollars contributed by her employer to a foreign retirement fund in which she is fully vested. No treaty article applies. What does she report for the year?

Answer: The 9,000 dollars, in gross income. The fund is not a trust exempt under IRC § 501(a), so § 402(b)(1) includes employer contributions in accordance with § 83, and vesting means there is no substantial risk of forfeiture to defer the inclusion.

2. Can she exclude it under the foreign earned income exclusion?

Answer: No. IRC § 911(b)(1)(B)(iii) removes amounts included in gross income by reason of § 402(b) from foreign earned income, and clause (i) removes pensions and annuities.

3. A taxpayer qualifies for relief under Rev. Proc. 2020-17. Which filings does that relief cover?

Answer: Only the information reporting under IRC § 6048. Section 4 of the procedure states that it does not affect reporting under § 6038D or any other provision, including the FBAR.

4. A client receives a state retirement pension from a foreign country. Is it taxed under the social security formula?

Answer: No. IRC § 86(d)(1) confines a social security benefit to a monthly benefit under title II of the Social Security Act or a tier 1 railroad retirement benefit. The foreign pension is ordinary income under § 61(a)(11) and also increases the sum that determines how much of any United States benefits is taxable.

5. Why does the timing of the United States tax on a foreign plan often strand the foreign tax credit?

Answer: Because IRC § 402(b)(1) can tax employer contributions as they vest, while the foreign country usually taxes the pension when it is paid. The credit under § 901(b)(1) is available in the year the foreign tax is paid or accrued, which may be decades after the United States tax, and the § 904 limitation applies in that later year.