Nonresident Aliens: Federal tax withholding from 401(k) and annuity payments
Updated: Oct 27, 2022
Nonresident aliens (NRA) are generally subject to tax on their US source income unless an exception applies. Payments from U.S. retirement plans such as tax-deferred 401(k) plans made to foreign nationals are subject to US income tax withholding unless exempted. But then most nonresident aliens want to know: How to cash their 401(k) and minimize the higher 30% tax rate? The below discussion is not for Roth 401(k) plans, but traditional and tax-deferred 401(k) plans. We are also not discussing the foreign country's domestic tax regulations with regard to the taxation of 401(k) distributions.
How did a foreign national end up with a 401(k) account?
For U.S. tax purposes and under the internal revenue service, a nonresident alien is a foreign national individual who is not a tax resident. A tax resident is generally a person who is a US citizen, green card holder, or a resident per the substantial presence test (SPT) as defined under IRC § 301.7701(b)-1. A foreign national may elect a treaty article if one exists between the United States and the foreign country to override the substantial presence test to be treaty as a nonresident alien.
Most often, foreign nationals come to the US on assignment or on local contracts for a few years before they return to their home countries. While on a work visa, foreign nationals become US tax residents due to their substantial presence in the US or by obtaining a permanent residency permit, known as a green card. Therefore, they are subject to tax on their worldwide income while working and living in the US. During this time and while living in the US and working for US employers, a foreign national becomes eligible and may contribute to a tax-deferred retirement plan, under title 26, IRC section 401. With little knowledge or without any future plan, the foreign individual may decide to contribute to a US retirement plan to benefit from the tax-deferred features and be subject to tax on a lower taxable earned income at both the federal and state (if applicable) levels. That sounds good to pay less tax while saving for the future, especially if the individual is unsure about where they will retire.
What are the tax consequences of withdrawals from 401(k) retirement plans?
Similar to all participants, tax resident aliens are subject to the rules of contribution to, and distribution from, the tax-deferred retirement plans. Therefore, they cannot take out money from the plans prior to being eligible without paying federal tax and early withdrawal penalty unless exemptions apply. Generally, normal distribution starts at the age of 59 ½ without the 10% early distribution penalty.
What are nonresidents' alien options with regard to their 401(k) while they are in a foreign country?
Am I required to take the money out? Should I withdraw it? What are my options?
You are generally in control as long as the plan is not obligated to distribute the vested money to you when you are separated from the U.S. employer. Therefore, you can either withdraw or leave it. Normal distribution starts at 59 ½. Prior to the date you reach that age withdrawal is considered early and a 10% early penalty may apply unless exempted. If you want to roll over the distribution, it must be deposited to another qualified U.S. retirement plan, otherwise, tax and penalty may apply.
How are distributions from 401(k) taxed if the recipient is a nonresident alien?
After a foreign national departs from the US and repatriates to his or her home country, he or she may want to take some or all of the money he or she has stashed in a 401(k)-retirement account.
401(k) plans are U.S. tax-deferred retirement plans. Payments from these plans to nonresident aliens are subject to 30% federal tax withholding under Title 26, U.S. Code § 871(a) and Title 26 U.S. Code § 1441. The 30% withholding is required unless documentation exists and the recipients can show they are U.S. persons or nonresident aliens that live in a country with which the US has a tax treaty and a lower tax rate applies. The required documentation includes form W-9 and Form W-8BEN. If no documentation exists, then the presumption rules may apply under the US treasury regulation section 1441-1(b)(3)(iii)(C).
Throughout the year, we receive inquiries from foreign nationals about how to cash out a 401(k) and how to minimize the US income tax withheld from periodic or lump-sum distribution.
How do I avoid taxes on my 401k withdrawal?
401(k) is traditionally a tax-deferred retirement account that grows tax-free until distributed. A nonresident alien may avoid paying US taxes on the distribution if the NRA home country has a tax treaty (usually article 17, 18, or 19) with the US and the home country has taxing priority of the distribution account. Just be aware that your home country may have a higher tax rate than the US. This is not an ideal situation for you! Also, be sure the tax treaty provides benefits.
What will happen to the 401k account for a nonresident who leaves the US?
That account is still yours and you do whatever you want with it. Unless the trustee requires you to take the money out, you can leave it to grow tax-free for US tax purposes. However, you should check your local country's tax rules related to owning a foreign retirement account. Your home country may require you to disclose the 401(k) account, pay tax on the grows, etc.
What is the process of cashing out a 401(k)?
First, tell the custodian that you want to withhold your 401(K) and to provide you with all the necessary paperwork. Then make sure you fill the required forms out correctly and provide a U.S. form W-8BEN to the withholding agent in order to benefit from a lower tax treaty rate if one exists. The tax treaty article number and the withholding rate must be included to claim the treaty benefit upfront. The withholding agent is required to report the payment and the tax withheld, if any, on the IRS Form 1042-S. The withholding agent has until March 15 (or the next business day if the 15th falls on Saturday, Sunday, or a federal holiday) to provide you and the internal revenue service with a copy of Form 1042-S. Be sure to ask if form 1042-S or Form 1099-R will be issued to you.
What treaty article applies, if one exists between your home country and the United States?
This IRS publication 901 provides the list of treaty countries along with a summary of a few benefits provided. However, you, or your tax advisor, should carefully review the full tax treaty and technical explanation for your applicable country or countries to get the maximum benefits provided by the treaty.
Are nonresident aliens required to file a tax return?
If you pay more federal tax than you should have, then you can request a refund by filling out and submitting the IRS Form 1040NR. If you are correctly withheld on form 1042-S, then a tax return may not be required unless you have other US tax reporting obligations.
Do I need an ITIN or SSN to file a tax return?
Yes, you do need a Taxpayer ID for a refund. If you do not have a US social security number, you may need to apply for an ITIN to receive a tax refund, if applicable. Use IRS Form W-7 to apply for the first time or to renew your ITIN. Refer to the W-7 instructions for more details. Reach out if you need help.
Will a 10% early withdrawal penalty apply to nonresidents who are under 59 and 1/2?
If you take an early distribution before you turn 59 ½, you generally are subject to an early withdrawal penalty of 10%, unless an exception applies. However, if you separate from service after reaching Age 55, payments received from the Plan are generally not subject to the Early Withdrawal penalty. there are many other exceptions for those under 55.
How to disclose a treaty-based position that reduces US taxes?
If you take the position that any U.S. tax is overruled or otherwise reduced by a U.S. treaty (a treaty-based position), you generally must disclose that position on Form 8833 and attach it to your return. If you are not required to file a return because of your treaty-based position, you must file a return anyway to report your position. The filing of Form 8833 may not apply to a reduced rate of withholding tax on US-sourced income not effectively connected income, such as dividends, interest, rents or royalties, or to a reduced rate of tax on payments received for services performed as an employee, including pensions, annuities, and social security. For more information, see Form 8833 instructions.
Individuals who fail to file Form 8833 may have to pay a $1,000 penalty. Corporations are generally subject to a $10,000 penalty for each failure.
What happens if there is no income tax treaty between the United States and the home country of the foreign national?
If there isn't an income tax treaty, you may still fill out the W-8Ben to indicate your tax status as a foreign national. Therefore, without a treaty providing a lower tax rate, the withholding agent may withhold and remit 30% of income tax from the 401(k) lump-sum withdrawal. However, because your contributions were from U.S. source income, they are effectively connected income. The growth portion may be FDAP (Fixed, Determinable, Annual or Periodic) income and it is subject to a 30% tax rate.
In this case, you may request a partial tax refund if your effective tax rate is lower than the 30% rate. However, be aware of the early withdrawal 10% penalty. Contact us for more information and if you need help.
How can Whin Global help?
If you have questions about this topic or need assistance with any U.S. expat tax issues and/or U.S. tax for foreign nationals living inside or outside of the United States, fill out this contact form or contact us at firstname.lastname@example.org.
Oh, and do not forget to review the relevant private letter rulings (even though these cannot be officially relied on), articles/discussions of the tax treaty, protocols and technical explanations of the tax treaty, special agreements between the US and the home country of the foreign nationals.
We are here to help if you seem lost.