For those considering renouncing their U.S. citizenship, the main potential tax concern is the so-called “exit tax,” which is a tax on the built-in appreciation in a covered expatriate’s property (such as a house), as if the property had been sold for its fair market value on the day before expatriation.
If you have a retirement savings account (i.e., a pension), however, a very different set of tax rules apply upon renunciation if you’re classified as a covered expatriate. These rules can be particularly harsh when they result in the double taxation of your savings, which you have worked so many years to accumulate in anticipation of your eventual retirement.
In this blog, we review the tax consequences of renunciation for covered expatriates, which apply particularly to retirement savings accounts.
Categories in the Internal Revenue Code
Section 877A of the U.S. Internal Revenue Code, which deals with the tax consequences of renunciation for a covered expatriate (including the exit tax rules), distinguishes between three types of items:
- Non-eligible deferred compensation items;
- Eligible deferred compensation items; and
- Specified tax-deferred accounts.
Each type is defined to include specific savings accounts, and each comes with its own particular tax consequences upon renunciation.
Deferred Compensation Items
So-called “non-eligible deferred compensation items” include foreign pensions, as well any other pension that doesn’t qualify under the rules of Section 401 of the Code.
In the case of a non-eligible item, an amount equal to the present value of the covered expatriate’s accrued benefit is treated as having been received on the day before the expatriation date as a distribution under the plan.
So-called “eligible deferred compensation items” include a 401(k) pension, as well as other Section 401-qualifying pensions.
When you renounce, the tax consequences are the same as for non-eligible items, unless you take certain steps to achieve a more favorable method of tax deferral, rendering the item untaxed until the pension is actually paid in the future.
These steps include a notification by the covered expatriate to the U.S. payor that he or she is a covered expatriate and an irrevocable election to waive any treaty rights with respect to “withholding on such item” when it is eventually paid. When a distribution is eventually made, the payor must withhold 30% from the payment.
Specified Tax-Deferred Accounts
Specified tax-deferred accounts include IRAs, 529 plans, and certain education and health savings accounts.
Upon renunciation, the covered expatriate is treated as receiving a distribution of his entire interest on the day before the expatriation date (and it should be noted that an early distribution tax is not imposed in such case).
The Risk of Double Taxation
With respect to all three categories, there is a risk of double taxation when a payment is made after the person has become resident in a foreign country.
Double taxation can occur if the local country taxes the payment and doesn’t allow a credit for the U.S. income tax that was paid.
Generally, mitigation of such double taxation is more likely where a deferred compensation item qualifies as eligible, making the payment of U.S. income tax proximate to any foreign taxes assessed on the actual payment.
Treaty relief may also be available, depending on the circumstances.
Importantly, deferred compensation items are exempted from any adverse consequences upon renunciation to the extent attributable to services performed outside the U.S. while the renouncer was not a citizen or resident of the United States.
In this regards, it’s not uncommon for non-U.S. citizens moving to the United States to “freeze” their rights in their foreign pension plan that covered them prior to the move. In this case, this exception may provide substantial relief from any withholding obligations or substantive tax liabilities.
Given the potential adverse tax consequences associated with renunciation, U.S. individuals should carefully consider the various pitfalls and opportunities available to them prior to making any lasting decision.