How 401k Withdrawals Are Taxed for Australian Expats?

How 401k Withdrawals Are Taxed for Australian Expats?

How 401k Withdrawals Are Taxed for Australian Expats?

 

How 401k Withdrawals Are Taxed for Australian Expats? A common enquiry we receive from Australian expats is how is the withdrawal of a US IRA (401(k), Roth IRA, TDA’s) going to be treated when they return to Australia. Now there are various type’s of Individual Retirement Account’s (IRA’s) which can be established in the US and the US employer’s offering usually guides the choice.

When a US-based Australian expat returns to Australia they have two decisions to make on their accumulated IRA:

  1. Do I withdraw now before I leave the US?
  2. Do I withdraw later when I have reached the mandated age of 59.5?

The tax treatment of both are very different from the perspective of the Australian Taxation Office and the IRS.

The first option assumes the Australian expat is a non-resident for tax purposes at the time of withdrawal, therefore the only tax they will pay will be to the Internal Revenue Service (IRS) and the amount of tax they pay will be dependent on their marginal tax rate, age and different components of their IRA.

Remember, it is usually common practice that you will incur a 10% penalty tax on top of other taxes if you withdraw your IRA before your mandated age of 59.5. The taxation by the ATO does not arise here because you are a tax resident of another country.

The second option is one which returned Australians face every year. At present the double taxation agreements between Australia and the US does not respect the preservation nature of either IRA’s nor Australian superannuation funds.

The tax treaty between Australia and the United States does account for accrued US pensions under employment for a government department, which is referenced in Article18(1)’ Subject to the provisions of Article 19 (Governmental Remuneration), pensions and other similar remuneration paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that State’.

The DTA at present does not account for privatised IRA’s and therefore taxation arises very differently. Taxation Ruling IT 2542, provides that ‘both countries may tax a United States non-government pension derived by a United States citizen resident in Australia – Australia under paragraph (1) of Article 18 of the Convention and the United States under its domestic law by reason of paragraph (3) of Article 1’. In order to provide an example of what the tax treatment would look like we will defer to Philip Hodgen’s treatment, whom is a US tax lawyer.

When you withdraw an IRA, after being back in Australia for a period it is more than likely the US tax system will treat you as a Non-resident Alien(NRA). Therefore, the IRA plan provider will deduct the 30% applicable withholding tax and send this amount straight to the IRS. However, depending on the taxable components within your IRA, this could mean you pay less or more than this 30% Withholding Tax.

An NRA can be taxed by the US in one of two ways:

  1. If the U.S. source income received by that person is passive in nature (interest, dividends, etc.), the tax rate is 30%. (IRC s871(a))
  2. If the U.S. source income received by the non-resident alien is active in nature (“effectively connected with the conduct of a U.S. trade or business”, to use the tax vernacular), then the income is taxed at the normal tax rates – the more money you receive, the higher the tax rate. (IRC s871(b))

 

Example of How 401k Withdrawals Are Taxed for An Australian Expat

 

Joanne is 60 and returned back to Australia 15 years ago. Prior to her repatriating back to Australia she lived and worked in the US as a US tax resident. In that time she elected to take up a traditional 401K(IRA) with her employer and when she returned to Australia she left it over in the US until she wanted to withdraw it.

Joanne initially considered withdrawing it when she left but she did not want to incur the 10% penalty tax as well as any extra income tax she may had to pay in the United States. Today Joanne’s 401k is worth USD$350,000 or AUD$480,322. Joanne wishes to transfer the entire lump sum back to Australia and therefore wishes to know the total amount of tax she will pay. Joanne has just retired and has no other income except her account based pension which is tax-free.

The US tax system will treat Joanne as an NRA and therefore deduct the standard 30% withholding tax, however Joanne’s actual tax liability might be more or less than 30%.

IRA Taxable Components:

  • Pre-Tax Contributions: USD$200,000 (IRC s871(b))
  • Investment Earnings: USD$150,000 (IRC s871(a))

 

Internal Revenue Service Tax Treatment

 

US Taxable income (401K Withdrawal) USD$350,000
US Flat 30% Withholding Tax USD$105,000
Actual Tax Payable USD$86,850
Tax Refund on US Tax Filing USD$18,150
Net Income USD$263,150

 

Joanne therefore must pay the IRS USD$86,850 in tax on her 401K withdrawal. This means when she brings the funds back to Australia she will be required to declare the lump sum payment of AUD$480,322 but she will be entitled to a AUD$119,189 foreign tax credit.

A foreign tax credit is given based on the tax that Joanne has already incurred for withdrawing while she is a normal tax resident of Australia. Remember as Joanne’s 401K is a traditional IRA, this means everything that has been contributed is pre-tax and therefore taxation arises on the full lump sum. The net income Joanne will  bring home is AUD$361,134.

 

Australian Taxation Office Treatment

Taxable income (401K Withdrawal) AUD$480,322
Gross Tax Payable AUD$196,582
Foreign Tax Credit AUD- $119,189
Net Tax Payable AUD$77,393
Net Income after US/AUS tax AUD$283,740

 

After Joanne is taxed by the ATO she is left with AUD$283,740. The overall tax impact equates to 41% tax on the total lump sum, which is a significant amount. Joanne could have been a bit more tax efficient by not necessarily drawing the entire lump sum but perhaps considering a withdrawal over a 5 year period.

She could have also considered contributing amounts to superannuation as well in a concessional manner. If she was to employ such a strategy it could save her $1000’s over the strategy period.

Currently the ATO’s interpretation of the relevant tax law (ATO ID 2008/36) on US IRA’s, is that they be treated as foreign trusts rather than a foreign pension or super fund. This interpretation is further supported by the 2015 Administrative Appeals Tribunal case of Re Baker and FCT(2015).

However, the ATO is aware that not one size fits all when it comes to applying tax on such a lump sum withdrawal. The taxation of such a withdrawal will depend on the particular IRA account agreement, as the US has several types.

The ATO confirms that it recognises the distribution of such a lump sum from an IRA may consist of multiple components much like a superannuation fund:

  • Pre-tax contributions made by the Australian expat
  • Contributions made by the US Employer through a matching program
  • Investment income derived by the fund (this would include dividends, realised capital gains and other income such as interest)

 

Alternative Example of How 401k Withdrawals Are Taxed for An Australian Expat

 

If we were to consider an alternate scenario whereby Joanne had the following:

Joanne has a total IRA balance of USD$350,000 which is made up of USD$75,000 in a Roth 401K and USD$275,000 in a traditional 401K. The Roth 401K balance is made up USD$50,000 after-tax contributions and the USD$25,000 is made up from the earnings. The Traditional 401k is made up of $200,000 pre-tax contributions and $75,000 investment earnings.

 

Internal Revenue Service Tax Treatment

US Taxable income (401K Withdrawal) USD$275,000
Non-US taxable Income (Roth 401K) USD$75,000
US Flat 30% Withholding Tax USD$82,500 *
Actual Tax Payable USD$64,350
Tax Refund on US Tax Filing USD$18,150
Net Income USD$285,650**

*Only calculated on traditional 401K lump sum.

** Net Income plus Roth 401K Income

As the Roth IRA was entirely a qualified distribution, no further tax is due on this lump sum by the IRS. However, this will not be the same treatment by the ATO and therefore means that Joanne is required to pay USD$64,350 in tax to the IRS. However, this will equate to a AUD$88,311 foreign tax credit to the ATO.

 

Australian Taxation Office Treatment

401K Withdrawal AUD$376,916
Roth 401k Taxable Component AUD$34,265
Gross Taxable Income AUD$411,181
Tax Payable AUD$164,431
Foreign Tax Credit AUD- $88,311
Net Tax Payable AUD$76,120
Net Income after US/AUS tax AUD$ 315,367

 

Now you’ll note that the Roth 401k taxable amount is only USD$25,000 (AUD$34,265). This is because the USD$50,000 has already been previously taxed and is therefore a return of the tax-free corpus of the trust. You’ll also note that the average tax rate in the scenario on a total lump sum has been reduced to 34%, therefore it might be wise to target Roth IRA’s while you are based over in the US but this is dependent on your individual situation.

Joanne could have been a lot more strategic around withdrawing her IRA periodically and looking at doing some effective tax planning around this. With Joanne being fully retired now and only looking to use superannuation as her main income stream this means she has some room around a tax-free threshold and contributing to superannuation up to age 65 before a work test is required.

 

Confusion Surrounding How 401k Withdrawals Are Taxed?

 

As you can see working out how 401k withdrawals are taxed can be quite complicated especially if you are uncertain around the type of tax you might pay on its withdrawal. It is important to plan effectively when retiring and implement relevant tax minimisation strategies. It is always best to have such a situation reviewed by a qualified financial planning team, so you aren’t in for any nasty tax surprises.

 

James is an experienced financial planner who brings a multitude of skills and experience to the table when it comes to providing Australian expat financial advice. After completing university, James was an accountant for four years at which point he then moved into the financial services sector and became a financial planner. Combining his accounting skills with financial advice, James has advised individuals, families, and Self Managed Super Fund clients in the areas of retirement planning, debt reduction, cash flow management and portfolio management. James holds a Bachelor of Commerce with an accounting major, Bachelor of Business with a marketing major, Advanced Diploma of Financial Planning and is currently completing his Masters of Financial Planning.

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