Treatment of DB pension plan and 401K on 1040NR for Covered

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expat61
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Treatment of DB pension plan and 401K on 1040NR for Covered

Post by expat61 »

I'm going to be a covered expatriate. How will the IRS tax my US monthly DB pension plan payments and 401K withdrawals after I pay the exit tax and expatriate to a tax treaty country?

I understand that my monthly DB pension plan payments and 401K withdrawals will be subject to a 30% withholding at source.

But when I file my 1040NR each year, can I claim both as "effectively connected" income on page 1 line 17? Or do they have to be NEC on page 4 line 7 box (c)? Or some combination of either?

For example, if my annual DB pension in $50K and my monthly 401K withdrawals total $40K, then treating both as effectively connected income on page 1 results in tax of about $18K (tax table page 72). Which would give me a $12K tax refund each year.

Treating them as NEC gives me no refund.
expat61
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Post by expat61 »

(edit) ..
Which would give me a $9K tax refund each year.
nelsona
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Post by nelsona »

First your DB will only be taxed at 15% by treaty, and your 40(k) *should* only be taxed 15%,. None should be subject to any penalty even if under 59.5. A w8-BEN should be sufficient t oget those rates.


But, yes, you may report one or both as effectively connected "page 1" income.

Canada will expect you to have taken all steps required to reduce the tax to 15%, so will not grant more than that in credit, so it is in your interest to lower the US tax as much as possible.
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nelsona
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Post by nelsona »

When I say "should only be taxed 15%", I mean should only have 15% withheld. In that case, you wouldn't ewven have to bother with the tax return.

I am assuming you are moving back to Canada.
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expat61
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Post by expat61 »

nelsona : Thanks for that answer but now I'm confused.

I thought being a covered expatriate meant an automatic 30% withholding (not eligible to be reduced by treaty) and a 30% tax on all NEC income (i.e. everything declared on page 4).

If it only means 30% withholding and everything else is treated the same as a non-covered expatriate, then the only main issue with being covered is cash flow once you have expatriated. (Ignoring any actual tax at exit or long term gift estate tax issues)

If true, this makes the consequences of expatriating as covered or not-covered almost trivial for many people (like me) headed back to Canada.
nelsona
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Post by nelsona »

That is how I understand it. Once expatriated, the treaty overrides these punitive measures.
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expat61
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Post by expat61 »

That makes sense to me too. Thank you.

Summary : if you send a W-8CE to your DB pension plan and 401K administrators (within 30 days of expatriation), they withhold 30% at source (regardless of any treaty rates) and you file a 1040NR each year to get the treaty rate (15% if Canada) applied - resulting in a refund of the other 15%.

It's amazing how hard it is to tease a simple explanation like that out of anything you can find published online (especially the IRS guidelines).
nelsona
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Post by nelsona »

There are a couple of websites (Isaac brock?) that deal extensively with Cdns giving up citizenship, that would have exact answers to some of these q's.
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expat61
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Post by expat61 »

Thanks nelsona. FWIW, I'm headed the other way - expatriating from the USA (long term LPR & covered expatriate) back to Canada (citizen).

I'd love a link to any websites that simplifies or clearly explains that process. Most of what you find is basic high level stuff designed to scare people and attract legal/accounting clients. Some of it is fluff, some of it is simplistic, some of it helps, and some of it is just plain wrong.
nelsona
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Post by nelsona »

That's what I meant. Cdns giving up US citizenship.
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nelsona
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Post by nelsona »

http://isaacbrocksociety.ca/how-to-renouncerelinquish/

A bit heavy on the hyperbole, but will have all the experiences.

Thought you would have found them by now.
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expat61
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Re:

Post by expat61 »

nelsona wrote:
> That is how I understand it. Once expatriated, the treaty overrides these punitive measures.

Keep meaning to come back and correct this. I did a bunch more searching and asked this question of the international tax lawyer I work with. My understanding was wrong.

Once you are determined to be a covered expatriate, all future taxes due in the USA are calculated at 30% - you lose the ability to apply treaty reduced rates and should not try to use them when filing tax returns.
nelsona
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Re: Treatment of DB pension plan and 401K on 1040NR for Covered

Post by nelsona »

I'm not so sure I agree with that statement. At the time of expatriation you may not be able to use treaty, but certainly afterwards you should be allowed to. That is the point of expatriation.
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nelsona
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Re: Treatment of DB pension plan and 401K on 1040NR for Covered

Post by nelsona »

On second reading, yes, specifically trust income is not to be reduce by treaty.
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expat61
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Re: Treatment of DB pension plan and 401K on 1040NR for Covered

Post by expat61 »

Per the title of the thread, I'm talking about a USA DB pension plan and 401K. I'm not sure if that's what you mean by "trust income"?

Regardless, the rules are brutally clear. If you expatriate as a "high net worth" individual as defined by the IRS (or don't have clean tax returns for recent years) then you are considered a covered expatriate. And the IRS will tax all deferred tax items (IRAs, stocks, homes, other investments) as if you had cashed them out the day before you expatriated.

Defined benefit pension plans and 401K's get special treatment for covered expatriates. While they are not taxed on exit like an IRA, all income from those after you leave gets taxed @ 30% via a 30% withholding that you won't get back. The 30% cannot be reduced by any tax treaty. You make that irrevocable election when you choose not to have your DB pension or 401K taxed fully on expatriation.
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