February 15, 2022

US citizens residing abroad frequently join in foreign pension schemes, which typically enjoy favorable tax status under the laws of the country of residency. Moreover, membership may be made mandatory, and companies regularly pay significant pension contributions on behalf of their employees.

Even with all these advantages, American taxpayers should be aware that not all overseas pension plans obtain favorable tax treatment under US tax regulations, and that participation may be damaging to long-term financial planning goals.

U.S. taxpayers with foreign pensions must carefully assess their pension plans under relevant U.S. tax legislation and bilateral tax treaties to avoid retirement planning pitfalls. Foreign pension is a sector that US taxpayers can no longer disregard, as the Foreign Account Tax Compliance Act (FATCA) and Passive Foreign Investment Company (PFIC) rules are now being implemented by the IRS.  Growing cross-border tax compliance imply that the IRS may take a deeper look at these investments in the future (especially so-called “offshore pension schemes”).

American Taxpayers and Foreign Pension Schemes

Many countries permit employees to put pre-tax cash into retirement accounts, which grow tax-free until retirement. These tax-deferred savings and investment systems exist globally for the same purpose they exist in the United States: governments aim to encourage employees to accrue private savings to fund retirement expenses rather than relying solely on state pension systems.

Regrettably, the United States’ global system of citizen-based taxes was implemented before modern pension systems and well before the emergence of a globally mobile labor force. As a result, current US tax regulations do not promote membership in most overseas pension plans, and the IRS typically considers foreign pension plans, including those that are “qualified” under local tax rules, to be “nonqualified” under US tax standards.

This puts a damper on retirement savings for US expats living abroad.  Not only do they lose the tax advantages of an employer sponsored retirement plan in their US tax returns, but they may also be subject to punitive taxes, penalties and interest in their US tax returns as a consequence of FATCA and PFIC compliance.

Staying Compliant: Foreign Pension Reporting for U.S. Taxpayer

One significant unforeseen effect of the FATCA law is that U.S. taxpayers who participate in overseas pension plans will no longer be able to casually forget to mention their involvement in these programs on their US tax returns.

Prior to FATCA, membership in foreign pension plans by American expat employees frequently lured them into a pattern of systematic lack of compliance – many investors did not even consider reporting these pension schemes until retirement benefits began. However, FATCA now gives the IRS a feasible vehicle for enforcing laws mandating foreign pension schemes to be disclosed and taxed to a degree that was not before conceivable.

Fortunately, FATCA rules include several exemptions that protect some foreign retirement and pension funds from FATCA reporting. This implies that the identity of pension account holders would not be automatically submitted to the IRS. This does not, however, imply that Americans with overseas pensions can disregard these assets when submitting a tax return in the United States. To avoid IRS penalties and fines, U.S. taxpayers must take prompt action to record overseas pension assets on their annual tax returns.

To make matters worse, accurately reporting a foreign pension on a US tax return is a time-consuming and costly accounting procedure. Form 8938, Foreign Bank Account Report (FBAR or FinCen 114), and probably Form 3520 related to U.S. shareholders of foreign trusts will be required for participation in a foreign pension.

If the pension is designated as a grantor trust and does not fulfill certain conditions, Form 8621 reporting for Passive Foreign Investment Companies (PFICs) may be obliged to report underlying investments. Effective compliance is challenged by a lack of information from the foreign pension plan administrator and ambiguity among tax preparers about the optimum reporting procedures.

There is also considerable uncertainty among tax professionals over the applicability of US tax regulations and tax treaties to such nonqualified schemes. However, numerous broad generalizations concerning international pension tax compliance may be drawn.

To begin, the taxpayer must normally include in their gross income the sum of vested pension payments made by both the employer and the employee. They may also be obliged to include unrealized investment earnings on plan assets in their gross income.

Finally, depending on the jurisdiction and mode of distribution, taxes may be payable upon final payout from the pension plan.

Integrating Foreign Pensions with a Comprehensive Retirement Plan

The lack of treaty protection and tax qualified status does not necessarily rule out membership in a foreign pension plan. Various methods may be utilized to make investments within pension plans tax compliant and efficient in the United States. Whatever reporting technique is adopted, it is critical to maintain the tax treatment consistent throughout filing years. Employing multiple procedures to submit and report the pension from year to year raises the possibility of double taxation.

Excess overseas tax credits are likely to accrue if an American investor lives in a country whose income tax rates are higher than those in the United States. Moreover, if there is no treaty provision allowing for a U.S. tax deduction for local pension payments, contributions will only lower current taxation in a particular region.

Contributing to the plan, however, decreases net current taxes since there are still adequate foreign tax credits available to cover all the associated U.S. tax on these payments. Furthermore, the pension plan now has a tax basis equivalent to the initial contribution amounts for US tax accounting reasons.

At retirement, the distribution of returns from this basis, may be tax-free in the United States. As a result, when no treaty provision applies to qualify the local pension for US tax reasons, optimal planning would demand payments to the local pension in a level that equalizes the local tax owed with US tax, generating no excess foreign tax credits. This method provides the advantage of utilizing foreign tax credits (which would otherwise go unused) and decreasing the degree of U.S. taxes on future distributions.

Finally, even if net US and local taxation of pension plans is negative, substantial employer contributions and employer tax equalization schemes may make pension plan membership beneficial for generously compensated US expats.

A prevalent misperception is that money from a foreign pension plan can be rolled over into a U.S. qualified retirement plan, such as a 401k, IRA, or Roth IRA account. Unfortunately, with any kind of overseas retirement account, this is never conceivable.

A much more usual case is that a foreign nation will permit an expat to make a withdrawal when they emigrate permanently. The capacity to withdraw funds from a local plan varies by jurisdiction. This alternative must be investigated under the laws of the country of residency, with the aid of a local legal/tax professional.

What should U.S. Expats do with Foreign Pensions?

FATCA effectively forces the IRS to address the issue that the United States’ global taxation system is incompatible with regular participation in traditional ways of retiring and investing for American employees overseas.

Nevertheless, because these FATCA issues have yet to be settled, US taxpayers are unable to ignore international pensions. US expats must get acquainted with the tax regulations that apply to their overseas pensions. Given the possible tax exposure and hefty fines, it is critical to prepare ahead of time in order to understand the tax treatment of these pension schemes as well as their tax reporting obligations.

To prevent future issues, Americans residing abroad ought to be aware of the tax treatment of contributions to and distributions from these foreign plans—distribution taxes must be reduced, fees minimized, and the pension plan’s investment alternatives must be evaluated.

Following due deliberation, it may be inefficient for a US expat to engage in a foreign pension plan or just maximize their contributions. To maximize tax efficiency and optimum after-tax returns for successful retirement saving and higher total wealth generation, proper asset allocation across several accounts such as a taxable brokerage, 401k, IRA, Roth IRA, and a foreign pension is necessary.

Most Americans living overseas will eventually discover that onshore assets in the United States, managed with an eye toward tax efficiency and cross-border tax compliance, are the ideal means of generating wealth.

This is just the tip of the iceberg.  On the flipside, other countries don’t appreciate the tax benefits on US retirement accounts i.e., 401k, IRA, Roth, making retirement savings like a double edge sword for US expats. Needless to say, that in order to avoid double taxation, Americans who own retirement accounts, whether foreign or domestic, should keep organized records of taxes they paid on these accounts.  But this is a topic for another discussion.

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