If you’re here, you probably have a foreign retirement plan. Maybe you’re a U.S. citizen that worked outside of the country for a few years or maybe you lived and worked abroad before immigrating to the U.S., but either way, you’re left wondering why making responsible decisions and saving for your retirement is rewarded with excessively complicated tax filing obligations with the U.S.
Some related blogs with detailed information on specific foreign retirement issues are:
Foreign Grantor Trusts: Form 3520, Form 3520-A, and Revenue Procedure 2020-17
Revenue Procedure 2020-17: Form 3520, Form 3520-A….. Relief?
When a Foreign Retirement Plan is a 402(b) Employees' Trust
There are primarily two types of retirement plans: defined benefit plans and defined contribution plans.
Defined benefit plans are often referred to as pensions, they often start to pay out monthly once retirement starts and there is not an account associated with your interest in your defined benefit plan. This also means that there are not underlying investments associated with YOUR interest in your plan. The U.S. analogue would be the typical government pension, put in your x number of years, and receive a pension for the rest of your life.
Defined contribution plans are investment accounts that normally have a host of restrictions. With defined contribution plans, the performance of the underlying investments directly impacts the retirement funds that will be available to you. The U.S. analogue would be the 401(k). The variability of expected benefits based on the performance of the investments will always mean that it is a defined contribution plan. There are many foreign retirement plan statements that are written as though they are describing the monthly benefit you will receive once you retire, but that these amounts are entirely driven by the performance of the underlying investments, making them defined contribution plans.
Alright, now that we’ve gotten through an overview of the two types of plans and you can identify whether your retirement plan is a defined contribution plan or a defined benefit plan, we can determine how you have to move forward.
Defined benefit plans are much easier to report to the IRS. You have to include any distributions from your defined benefit plan in income and you also have to include those distributions on your Form 8938 as an ‘other asset’. That’s it.
Defined contribution plans require a lot more investigation a potentially a considerable amount of additional reporting to the IRS. If you have a defined contribution plan, we have to report your interest in this account annually on both Form 8938 and on your FBAR. The contributions to your plan, whether made by you or by your employer, have to be included in your income (there are a few treaties that will prevent the inclusion of these amounts in your U.S. taxable income) and it is also worth mentioning that your employer’s contributions cannot be excluded from your income using the foreign earned income exclusion (Form 2555).
The next important question for U.S. tax purposes is: is your defined contribution plan an employee’s trust or a grantor trust? This question normally boils down to how the plan was funded and how the plan is managed. Employee’s trust is a technical term in the U.S. tax code; for your plan to be an employee’s trust, your contributions to that plan must be ‘incidental’ to the employer contributions. Here, incidental means equal to or less than. So, if your employer put more money into the plan on your behalf than you did, there is a strong chance that you have an employee’s trust. If, however, you put more money in than your employer, or all of the money in the case of a retirement account that wasn’t associated with your employment, then you are going to be treated as having an interest in a foreign grantor trust.
Foreign grantor trusts ordinarily require substantially more reporting than employees trusts. Both types of retirement plans require FBAR and 8938 reporting and both require income inclusion of amounts contributed. Employee’s trusts are taxable when distributed (under the annuity rules in IRC 72, giving you credit for your ‘investment in the contract’ which in this case is the after tax money that you contributed). You are not treated as the owner of the underlying assets of an employee’s trust. So the entirety of the reporting for your interest an employee’s trust boils down to income inclusion of contributions and distributions and yearly disclosure of the account on your Form 8938 and on your FBAR.
Grantor trusts, on the other hand, are treated as though you directly own all of the underlying assets. Contributions, when made through employment, do have to be included in income, but distributions from grantor trusts are never included in income. Because you are treated as owning the underlying assets, you have to report any income associated with those assets annually. This means if there are dividends in your retirement account, you include them on your Schedule B. If there are capital gains in your retirement account, you include them on your Schedule D. And most probable, if there are PFICs (foreign mutual funds) in your retirement account, you have to do all of the associated Form 8621 reporting.
Grantor trusts also require Form 3520 and Form 3520-A reporting, forms that come with very substantial penalties for failing to file them or for filing them in a way that is ‘not substantially complete’. Form 3520 captures contributions to a foreign grantor trust, ownership of a foreign grantor trust, and distributions from a foreign grantor trust. The IRS has the ability to impose penalties on individuals for failing to disclose all three (contributions, ownership, and distributions.)
If you have a foreign retirement plan, sure, there is a chance you can sort this maze out on your own, but with the amount of potential penalty exposure (50% of the account value for the FBAR, 10k per Form 8938, percentage based penalties//or 10k per 3520 and 3520-A) it’s probably worth bringing in a professional who is familiar with the disclosure of foreign retirement accounts to the IRS.