The Treatment of IRA & 401(k) Plans at Expatriation
When a US Citizen of Long-Term Lawful Permanent Resident formally expatriates from the United States tax system, they may become subject to exit tax if they are considered a Covered Expatriate. There is a common misconception that Taxpayers are only subject to US Exit Tax on certain (unrealized) mark-to-market gains — but there are other types of income scenarios that can lead to exit tax as well. Two common situations for US taxpayers are when they have a 401(k) or equivalent and when they have an IRA – the latter of which can be impacted by whether it is a traditional IRA or a Roth IRA. Let’s summarize the basics of the treatment of IRA & 401(k) plans at expatriation.
What is Expatriation?
Expatriation is the formal process of either renouncing US citizenship or relinquishing US persona status for a Long-Term Lawful Permanent Resident (only “long-term” permanent residents are subject to the formal expatriation process). At the time of expatriation, the IRS requires taxpayers to determine whether they meet either the net-worth test; the net income tax liability test, or the 5-year certification test. If the person is not a covered expatriate, then there is generally no exit tax implication – but there can be lingering tax and reporting issues for specified tax-deferred accounts (IRAs) and eligible deferred compensation (401K).
401K at Expatriation
When a Taxpayer is a US Citizen or LTR, they are required to complete Form 8854 (Initial and Annual Expatriation Statement). Whether or not the Taxpayer is a covered expatriate or not does really impact the expatriation on the issue of a lump-sum exit tax. That is because whether or not the person is a covered expatriate or not, exit taxes can (usually) be avoided on the 401K. For the covered expatriate, they must jump through a few hoops (30-day rule), but as long as they follow the requirements, exit tax is avoided; in other words, there is no lump-sump exit tax required – although some taxpayers still select the gross-up at expatriation option.
Waiver of Treaty Benefits
The key issue becomes that when a person expatriates, they irrevocably waive the right to seek treaty benefits (if they reside in a treaty country), to reduce the withholding according to the treaty – which means the US Government will withhold 30% of the income as a non-resident alien, for tax purposes.
The expatriate may need to continue filing an annual expatriation statement to report on the 401K unless they cashed it out at expatriation and elected to pay the exit tax – if applicable.
IRA & Expatriation
An IRA qualifies as a specified-tax deferred account and is not the same as eligible deferred compensation – which also means it is treated differently for tax purposes. Generally, that means the investment loses its tax-deferred status at exit — and the Taxpayer will have to pay an exit tax on the value if they are a covered expatriate. For the traditional IRA, it usually means the full value is grossed up (there is no mark-to-mark, as there is no tax basis). If the person is not a covered expatriate, then is generally no tax implications.
If the IRA is a Roth IRA and not a traditional IRA– which means taxes were already withheld – the Taxpayer may escape any exit tax – even if they are covered – presuming the requirements for Roth IRA were properly met.
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