Foreign Pension Tax: Rules and Reporting for U.S. Persons
U.S. tax law treats foreign pensions differently than domestic plans, creating unique and complex obligations. Learn how to navigate your tax and reporting duties.
A foreign pension plan is a retirement arrangement established outside the United States, through a foreign employer or government. Because the United States taxes its citizens on worldwide income, these plans create tax complexities. The favorable tax treatment for domestic plans like 401(k)s does not apply to most foreign counterparts. This disparity can lead to U.S. tax liabilities on pension contributions and growth, even before any funds are withdrawn. The rules governing the U.S. taxation of foreign pensions differ from the tax laws of the country where the plan is located.
U.S. Tax Treatment of Contributions and Growth
Unlike a U.S.-based 401(k), contributions to a foreign pension are not deductible on a U.S. income tax return, meaning they are made with after-tax dollars. Any contributions made by an employer to a foreign pension plan are also considered taxable compensation to the employee in the year they are made.
The Internal Revenue Service (IRS) classifies many foreign employer-sponsored pension plans as “foreign grantor trusts.” Under these rules, the U.S. person is treated as the owner of the pension assets and must report and pay U.S. income tax on the plan’s earnings each year. This annual taxation applies to all income generated within the pension, including dividends, interest, and capital gains, regardless of whether the funds are distributed. The complexity increases if the foreign pension invests in Passive Foreign Investment Companies (PFICs), such as foreign mutual funds, which are subject to a separate set of U.S. tax rules.
U.S. Tax Treatment of Distributions
When a U.S. person receives distributions from a foreign pension plan, the rules aim to prevent double taxation on amounts already subject to U.S. tax through the concept of “basis.” This basis is the total money in the pension that has already been taxed by the U.S., composed of after-tax contributions and any investment growth taxed annually.
When a distribution is received, only the portion of the payment that exceeds the pro-rata share of the basis is taxable income. For example, if a person’s basis is $50,000 and the plan’s total value is $200,000, then 25% of any distribution is a tax-free return of basis, while the remaining 75% is taxable.
If the foreign country also taxes the distributions, the individual may face taxation in two countries on the same income. To mitigate this, U.S. tax law allows for a Foreign Tax Credit. By filing Form 1116, an individual can claim a credit for income taxes paid to the foreign government, which directly reduces the U.S. income tax liability on the pension income.
The Role of Tax Treaties
Default U.S. tax rules for foreign pensions can be altered by bilateral income tax treaties. The United States has agreements with numerous countries to prevent double taxation, and a treaty can override the Internal Revenue Code to offer more favorable treatment for contributions, growth, and distributions. For instance, a treaty might allow for tax-deferred growth of earnings or permit U.S. tax deductions for employee contributions.
A component of U.S. tax treaties is the “saving clause,” which preserves the right of the United States to tax its citizens on their worldwide income as if the treaty did not exist. However, the saving clause itself contains exceptions. The articles related to pensions are often exempted, meaning the treaty’s favorable pension rules can still be applied by U.S. citizens.
If a taxpayer’s U.S. tax liability is determined by a treaty provision, they may be required to disclose this position to the IRS. This is done by filing Form 8833, “Treaty-Based Return Position Disclosure Under Section 6114 or 7701.”
Required Information Reporting
U.S. persons with foreign pension plans are subject to information reporting requirements. These obligations promote transparency regarding foreign financial assets held by U.S. taxpayers. Failure to file these forms can lead to significant penalties, even if no tax is due.
FinCEN Form 114 (FBAR)
FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), is filed with the Financial Crimes Enforcement Network (FinCEN), not the IRS. An FBAR must be filed if a U.S. person has a financial interest in or signature authority over foreign financial accounts and the aggregate value exceeds $10,000 at any time during the year. A foreign pension plan is a reportable account for FBAR purposes. The form is filed electronically and is due by April 15, with an automatic extension to October 15.
Form 8938 (Statement of Specified Foreign Financial Assets)
A foreign pension may also need to be reported on Form 8938, which is filed with an individual’s U.S. income tax return. This form applies if the total value of specified foreign financial assets exceeds certain thresholds, which are higher than the FBAR’s and vary by filing status and residency. For an unmarried individual living in the U.S., the threshold is met if assets exceed $50,000 on the last day of the year or $75,000 at any time during the year. Form 8938 can include a beneficial interest in a foreign pension plan.
Forms 3520 and 3520-A (Foreign Trust Reporting)
The classification of many foreign pension plans as foreign trusts can trigger reporting on Forms 3520 and 3520-A. Form 3520 is filed by the U.S. person to report transactions with the foreign trust, such as contributions or distributions. Form 3520-A is an information return of the foreign trust. Since a foreign pension administrator is unlikely to file a U.S. tax form, the U.S. beneficiary is required to file a substitute Form 3520-A to avoid penalties. The penalty for failing to file can be the greater of $10,000 or 5% of the trust’s assets. IRS Revenue Procedure 2020-17 provides exemptions from this reporting for certain tax-favored foreign retirement trusts.