We have an overview for the U.S. reporting associated with foreign retirement plans here, and we have a review of the grantor trust reporting requirements with an excerpt on bifurcation here, but in this article we are going to go into a bit more detail what makes a foreign retirement plan an employees’ trust and what the associated reporting obligations are for that employees’ trust.
First, let’s walk through how to determine if your foreign retirement account is an employees’ trust. This determination ordinarily turns on the contributions, but let’s start with a review of the account generally:
How was the account setup? Employees’ trusts are generally set up by the employer.
Was it created through your employment or by your employer? Employees’ trusts are generally created through your employment and by your employer.
How much control are you able to exercise over the account? Can you choose between a list of eligible investments? Can you invest in anything you’d like? Are there no investment options? Employees’ trusts generally have a limited number of investment options, usually a curated list of mutual funds and in some cases there are no investment options.
These factors aren’t irrelevant, and there is generally a significant amount of overlap between these types of factors and the funding of the retirement plan, but as we’ve mentioned, the driving factor in determining if your retirement plan is an employees’ trust is the actual contributions.
You’ve likely previously heard that if the employer put in 50% or more of the total contributions, your foreign retirement plan is likely an employees’ trust, but let’s take a few moments to cover what makes this true.
The relevant tax code section for employees’ trusts is Internal Revenue Code Sec. 402. (https://www.law.cornell.edu/uscode/text/26/402)
402(a) applies to exempt trusts, to be an exempt trust, a plan has to meet a host of requirements under 501(a) (your foreign retirement plan does not meet these requirements).
402(b), Taxability of Beneficiary of Nonexempt Trust, describes the taxation of retirement plans that are employees’ trusts but aren’t exempt plans.
IRC 402 doesn’t define what is and what is not an employees’ trust, but if we take a detour into 1.402(b)-1 of the regulations (https://www.law.cornell.edu/cfr/text/26/1.402(b)-1) we will find some guidance:
“(6) Treatment as owner of trust. In general, a beneficiary of a trust to which this section applies may not be considered to be the owner under subpart E, part I, subchapter J, chapter I of the Code of any portion of such trust which is attributable to contributions to such trust made by the employer after August 1, 1969, or to incidental contributions made by the employee after such date. However, where contributions made by the employee are not incidental when compared to contributions made by the employer, such beneficiary shall be considered to be the owner of the portion of the trust attributable to contributions made by the employee, if the applicable requirements of such subpart E are satisfied. For purposes of this paragraph (6), contributions made by an employee are not incidental when compared to contributions made by the employer if the employee's total contributions as of any date exceed the employer's total contributions on behalf of the employee as of such date.”
The first thing worth explaining is that subpart E, Part I, subchapter J, chapter I specifically refers to the grantor trust rules (IRC 671-679). This above excerpt from 1.402(b)-1 is addressing when a beneficiary of a retirement plan won’t be treated as the owner for grantor trust purposes, resulting in the particular retirement plan being treated as an employees’ trust.
When employee contributions are “incidental” the employee will not be treated as the owner of the plan, and, as you can see in the above excerpt, incidental is defined as the employee putting in 50% or less of the total contributions relating to the employee’s interest in the plan.
Now you have a pretty good idea regarding how to determine if your retirement plan is an employees’ trust and an abridged understanding of IRS guidance that establishes when a trust is an employees’ trust. The next question is, after you determine you have an employees’ trust, what are the applicable reporting obligations.
The yearly informational reporting for an interest in a foreign retirement plan that is an employees’ trust will include Form 8938 and an FBAR to report the value of your beneficial interest in the plan. These requirements apply regardless of whether contributions or distributions are being made to/from the plan.
The income reporting associated with an employees’ trust specifically applies to the contributions and distributions from the plan. Contributions are always taxable income (unless a specific treaty provision applies, I’m looking at you UK). If you have an understanding of U.S. retirement plans, you should consider a foreign employees’ trust to be similar to a roth 401(k) in terms of the taxability of the contributions.
The distributions are taxed under the annuity rules of IRC 72. This, unfortunately, can be fairly complicated. The short version is that you are taxed on the amounts that haven’t already been subjected to income tax. This means if you were born a U.S. citizen but you lived and worked in Switzerland for a number of years, opening a mandatory Pillar II employees’ trust through your employer, the contributions to that retirement plan are included in your income when they are made, which means that when you receive distributions, we will treat those contributions as your ‘investment in the contract’.
To explain this with some numbers: John contributed $50 each year for 10 years to his foreign retirement plan, John’s employer matched those contributions of $50 each year for 10 years. John includes his and his employer’s contributions to this plan on his 1040 each year. 20 years later John’s retirement account is worth $2,000. When he distributes this $2,000, he will be subject to tax on $1,000 of that distribution because the $500 he contributed to the plan and the $500 his employer contributed to the plan are treated as his investment in the contract.