Are 401(k) Distributions & Withdrawals Taxed for Nonresidents?

Are 401(k) Withdrawals Taxed for Nonresidents?

Are 401(k) Distributions & Withdrawals Taxed for Nonresidents: Oftentimes, a Person who is now a nonresident (and no longer a US Person) of the United States may have at one point in their career earned income in the United States — and accrued 401K or other types of deferred eligible pension. The 401K  is the most common type of deferred retirement and pension plan in the United States — and the one that tends to cause the biggest issue for nonresidents when it comes time to begin receiving distributions and dealing with the IRS. While the general withholding rate for a nonresident is 30% — there may be ways for the nonresident to minimize withholding and/or reduce taxes altogether — depending on whether or not there is a tax treaty in place between the country of residence and the United States, and whether or not the nonresident has other US income, such as real estate income and made an ECI election — although that comes with it’s own set of headaches. Lets’ go through the basics of nonresident 401K withdrawals and how the IRS may tax that income:

Common Nonresident 401K Example

Andrew is a nonresident of the United States who resides in a treaty country. Previously, Andrew worked in the United States and accrued a $500,000 in his 401K. Andrew is now 65-years old and has decided he wants to begin drawing down his 401K in the United States.

How do the US tax rules work for Andrew and the 401K?

Withholding for Nonresident 401K Income

Since Andrew is a nonresident of the United States, the general withholding rate is 30%. Therefore, Andrew may possibly be taxed 30% on the amount of income generated from the 401K. 

26 USC 871(a)

• • • (a) Income not connected with United States business—30 percent tax

      • (1) Income other than capital gains Except as provided in subsection (h), there is hereby imposed for each taxable year a tax of 30 percent of the amount received from sources within the United States by a nonresident alien individual as—

        • (A)interest (other than original issue discount as defined in section 1273), dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income,

        • (B) gains described in subsection (b) or (c) of section 631,

        • (C) in the case of—

          • (i) a sale or exchange of an original issue discount obligation, the amount of the original issue discount accruing while such obligation was held by the nonresident alien individual (to the extent such discount was not theretofore taken into account under clause (ii)), and

          • (ii) a payment on an original issue discount obligation, an amount equal to the original issue discount accruing while such obligation was held by the nonresident alien individual (except that such original issue discount shall be taken into account under this clause only to the extent such discount was not theretofore taken into account under this clause and only to the extent that the tax thereon does not exceed the payment less the tax imposed by subparagraph (A) thereon), and

        • (D) gains from the sale or exchange after October 4, 1966, of patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises, and other like property, or of any interest in any such property, to the extent such gains are from payments which are contingent on the productivity, use, or disposition of the property or interest sold or exchanged, but only to the extent the amount so received is not effectively connected with the conduct of a trade or business within the United States.

401K and Tax Treaties

The next question is to determine whether or not there is a Tax Treaty between the country in which Andrew resides and the United States. If there is a treaty, then the treaty may allow a reduced withholding on the income. If a treaty applies, Andrew will file a W8-BEN and identify what Article of the tax treaty that allows for the reduced withholding and — submit the W8 to the plan administrator in the United States.

W-8BEN (Part II)

• • • 9. I certify that the beneficial owner is a resident of within the meaning of the income tax treaty between the United States and that country.

    • 10. Special rates and conditions (if applicable—see instructions):

      • The beneficial owner is claiming the provisions of Article and paragraph of the treaty identified on line 9 above to claim a % rate of withholding on (specify type of income):

      • Explain the additional conditions in the Article and paragraph the beneficial owner meets to be eligible for the rate of withholding

Tax Treaty Source vs Residence for 401K Income

Beyond the concept of reducing the withholding and the overall tax liability for the nonresident receiving 401K distributions, is the idea that the pension income may be non-taxable by the United States. When it comes to pensions, different tax treaties have different requirements and rules — and it will (generally) be determined based on either:

• • • The residence of the taxpayer (private pension); or

    • Source of the payment (Social Security and public pension).

Then, the Taxpayer may be able to submit they Form 8833 along with their 1040-NR to take a treaty position as to why the United States does not have the right to tax the pension.

Two important things to keep in mind are:

• Some foreign countries may have a higher tax rate than the United states; and
• the saving clause may eliminate any tax benefit.

Therefore, it is important to evaluate the potential tax implications and consequences of a 401K withdrawal Before moving forward and reaching out to the administrator of the 401K plan.

About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.

Contact our firm for assistance.