In today’s global economy, millions of individuals work outside their home country at some point in their careers. Many of these individuals save for retirement through employer and personal retirement plans. While these non-U.S. pension plans are often granted a special tax-advantaged status in the country in which they are established, the United States generally doesn’t recognize the foreign jurisdiction’s tax treatment of pension assets. U.S. taxpayers who have an interest in such plans (including both U.S. persons who move abroad and establish a foreign pension and foreign nationals who have a foreign pension and later move to the U.S.) can find that foreign pension plans can create quite a U.S. tax headache.

U.S. income taxation of foreign pension plans

Very few foreign pension plans, whether employer plans or personal pension plans, are treated as “qualified” plans in the U.S. They therefore do not receive the same U.S. tax benefits as U.S.-based plans generally do. There are very few cases where a bilateral income tax treaty may allow for foreign pensions to be treated for some purposes as U.S. qualified plans (i.e. Canada, the UK). Otherwise, the U.S. owner of such a plan may be currently taxable in the U.S.

Generally, if a U.S. taxpayer is vested in a funded foreign employer pension plan, even if he or she cannot currently take distributions from the plan, the U.S. may tax current year employer contributions. If the employee is considered a “highly-compensated employee” (currently defined as individuals who earn more than $115,000 per year), the earnings and accretions in the foreign pension plan may also be taxable in the U.S. in the current year, in addition to the employer contributions.

The taxpayer will get “basis” in the plan for U.S. purposes for the amounts included in current year taxable income, and may therefore not be taxed again for U.S. purposes at a later date on these amounts. However, the foreign jurisdiction’s laws may not provide for an increase in tax basis in the plan for amounts that were taxable in the United States, as the employer contributions and earnings within the plan had not been taxed in the foreign jurisdiction (often not until distributions are taken from the plan). The result is a potential for double taxation. This is usually negated by the use of foreign tax credits, which offset U.S. income tax liabilities by the amount of foreign income taxes paid. However, it is possible that the timing mismatch of when each country determines that the individual has received taxable income prevents the use of foreign tax credits.

A U.S. taxpayer who has a foreign personal pension plan may face similar U.S. taxation on a current year basis. A foreign individual retirement pension plan is generally taxed by the U.S. as if it were a normal taxable account. Earnings and accretions within the individual pension plan may be taxable in the U.S. in the current year, even if they are tax-free in the country where the plan is located.

The U.S. tax implications of owning a foreign pension plan become even more serious if the plan holds foreign mutual funds. While a full review of the U.S. tax treatment of foreign mutual funds is beyond the scope of this article, it generally does not make sense for U.S. taxpayers to hold these funds. We have previously written about the prohibitive U.S. tax treatment of these funds here.

Beyond taxing – additional U.S. information reporting requirements

Ownership of a foreign pension plan by a U.S. taxpayer presents more trouble than “just” the annual income tax charged in the U.S. The following (non-exhaustive) list contains a brief description of some of the other issues and obligations that may be imposed on individuals holding foreign pension plans:

  • Form TD F 90-22.1 (“Foreign Bank Account Report” or “FBAR”): A U.S. taxpayer who has a financial interest in, or signature authority over, a foreign financial account(s) that in aggregate exceed $10,000 at any time during the year must report all foreign financial accounts on a FBAR form. The FBAR must report all foreign pension plans if the $10,000 threshold is met. The FBAR is not part of the tax return, but is filed separately by June 30 of the following year.
  • Form 8938 (“Statement of Specified Foreign Financial Assets”): In addition to the FBAR, a U.S. taxpayer who owns foreign financial assets, including foreign pension plans, foreign financial accounts, interests in foreign entities, and certain other financial assets, may need to file Form 8938 with their tax return each year. The filing thresholds depend on the taxpayer’s filing status and whether they live in the U.S. or abroad, and they vary from $50,000 to $600,000. The information reported on the Form 8938 is often similar to that reported on the FBAR, but both forms must be filed.
  • Form 3520 (“Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts”): Some foreign pension plans may need to be reported on Form 3520 if they are held in the equivalent of a trust. Transactions in the pension plan during the year may need to be reported, and the information required will depend largely on the specific nature of the foreign pension plan.
  • Form 3520-A (“Annual Information Return of Foreign Trust with a U.S. Owner”): This form must be filed with respect to any foreign pension plan the assets of which are treated as being owned directly by the U.S. taxpayer. The form is usually prepared and filed in conjunction with Form 3520.
  • Form 8621 (“Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund”): When the foreign pension plan holds foreign mutual funds, the U.S. taxpayer may need to file Form 8621 to report his or her interest in those funds, and to calculate the proper U.S. tax liability on those funds.
  • Form 8891 (“U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans”): U.S. taxpayers who have an interest in certain Canadian retirement plans (such as RRSPs) can make an election to defer taxation of the plan’s earnings until distribution under the U.S.-Canadian income tax treaty. However, in order to take this benefit, the taxpayer must file Form 8891 in order to make the election; otherwise, earnings will be currently taxable in the U.S.

Many of the above forms are complex and carry significant penalties for failure to file. The FBAR penalty can be up to the greater of $100,000 or 50% of the account balance per year; many of the other forms carry potential penalties of $10,000 or greater. In addition, failing to file required forms can extend indefinitely the period of time the IRS can audit a tax return.