For Americans living abroad, one of the trickier areas of U.S. tax law is the non-U.S. pension. Despite being a common feature of most people’s lives, the U.S. Treasury and IRS provide limited guidance in this area, particularly with respect to the taxation of pension contributions and earnings.
In this blog, we outline the main Internal Revenue Code provisions and Treasury regulations that inform how the rules are supposed to generally operate with respect to foreign pensions. Implementation of these rules in the daily lives of taxpayers is easier said than done and often requires the assistance and guidance of a tax professional.
Foreign Pension Contributions and Earnings – Key Rules
Under U.S. tax law, the key relevant provision of the Internal Revenue Code is Section 402(b).
Under Section 402(b), the taxation of employer contributions and earnings will depend on whether the foreign pension plan is “discriminatory” or not. In brief, a plan is considered discriminatory if it fails either of the following tests:
1. Section 410(b) – The plan must (a) benefit at least 70% of employees that are not highly compensated employees (the limit, subject to inflation, is $135,000 in 2022); or (b) benefit a percentage of employees who are not highly compensated employees which is at least 70% of the percentage of highly compensated employees benefitting under the plan; or (c) be an IRS-approved plan that meets a certain average benefit percentage test.
2. Section 401(a)(26) – For defined benefit plans, the plan must benefit at least the lesser of (i) 50 employees of the employer, or (ii) the greater of 40% of all employees of the employer, or 2 employees (or if there is only 1 employee, such employee).
In the case of non-discriminatory pension plans – employees must include employer contributions in income but not pension earnings. In practice, the common foreign pension plans will often be non-discriminatory because the local law either will require participation by employees (e.g., Israeli pension schemes) or will not allow plans to discriminate against particular employees (e.g., an Australian superannuation fund).
In the case of discriminatory pension plans, a highly compensated employee must recognize the difference between the current year ending value of the account and the previously taxed amounts as compensation income each year. This essentially includes employer contributions and plan earnings. It should be noted that as such, not only is the current-year-realized income subject to tax, but also any unrealized appreciation in the plan is taxed.
Foreign Pension Contributions and Earnings – Tax Treaty Provisions
Several U.S. income tax treaties allow deferral for U.S. taxpayers with respect to employer contributions and/or earnings associated with foreign pension plans.
The provisions of each treaty should be carefully reviewed to ensure that the particular foreign pension scheme at issue qualifies under the treaty.
A Treaty Example
The following are examples of some of the key considerations associated with the pension scheme article (Article 18) of the US-UK Treaty:
The US-UK Treaty offers a U.S. tax exemption (or more technically deferral) for U.S. citizens working in the U.K. who have a U.K. pension plan. Article 18(5)(a)(ii) exempts employer contributions and earnings associated with qualifying UK pension schemes. A “pension scheme” is not limited to plans that qualify as trusts for U.S. tax purposes. It includes “any plan, scheme, fund, trust or other arrangement established in a Contracting State which is: (i) generally exempt from income taxation in that State; and (ii) operated principally to administer or provide pension or retirement benefits or to earn income for the benefit of one or more such arrangements.”
Benefits accrued under the plan and contributions to the plan need to be attributable to the client's employment with the company offering the pension scheme.
The US-UK treaty relief is limited to the lesser of the amount of relief allowed for contributions and benefits under a pension scheme established in the United Kingdom and the amount of relief that would be allowed for contributions and benefits under a generally corresponding pension scheme established in the United States.
Based on the broad language of the UK Treaty, including in particular the Exchange of Notes, some take the position that in applying this limitation, such corresponding pension scheme can include a SEP IRA or 401(k), whichever is more advantageous.
In this regard, contributions to a SEP IRA cannot exceed the lesser of: (i) 25% of “compensation”, or (ii) $58,000 (for 2021), while contributions to a 401(k) cannot exceed the lesser of: (i) 100% of “compensation”, or (ii) $19,500 (for 2021) for employee elective deferrals, but $58,000 (for 2021) total for employee elective deferrals and matching and non-elective employer contributions. A key limitation to consider is that the relevant regulation (Treas. Reg. 1.415(c)-2)(c)(1)) specifically defines “compensation” to include employee elective deferrals but to exclude employer contributions.
As a final note, the amount of the exemption benefit is counted when determining that individual’s eligibility for benefits under a pension scheme established in the United States. Therefore, for example, contributions to a U.K. pension scheme may be counted in determining whether the individual has exceeded the annual limitation on contributions to an individual retirement account.
Given the complexities surrounding the taxation and reporting of foreign pensions, it’s highly recommended for U.S. expats with a foreign pension, even a simple and common one, to consult an expat tax professional to ensure that the plan is properly accounted for on their U.S. tax return.