Can Nonresidents Avoid 401K Tax by US Tax Treaty
The tax rules involving Nonresident Aliens and US income taxes can be very complicated — due to the fact that the United States follows a worldwide income tax model. In general, US Persons are taxed on their worldwide income — which includes Pensions such as 401K. In a typical situation, a US Taxpayer puts tax-deferred money into retirement while they are working and when they retire, they are entitled to take distributions once they reach a certain age — and then get taxed at their progressive tax rate, which tends to be lower than during their working years. But what happens when a Nonresident Alien who may have been employed in the United States previously and accrued income in a 401K or other similar retirement becomes a nonresident? Generally — subject to covered expatriate rules — if the nonresident is in a treaty country that taxes pension based on location/residence and not source — they can avoid U.S. tax. Let’s take a look at how the treaty provision works:
Typical 401K Pension Treaty Provision (Article 18)
Here is a common treaty provision that you would find in the Australia/US tax treaty:
- 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.
What this provision means, is that subject to article 19 which deals with government remuneration (which is typically taxed based on source and not residence) — a resident of Australia would only be taxed in Australia for income received from past employment.
Technical Explanation Summary
This Article deals with the taxation of pensions, social security payments, annuities, alimony and child support derived by individuals who are residents of a Contracting State or citizens of the United States.
Paragraph 1 provides that pensions derived and beneficially owned by a resident of one of the Contracting States in consideration of past employment, other than pensions covered in Article 19 (Governmental Remuneration), shall be taxable only in that State.
Why Not US Citizens and Lawful Permanent Residents Too?
The problem for US Citizen and Lawful Permanent Residents is something referred to as a Saving Clause — which is interwoven into international tax treaties — and essentially provides that unless an Article is exempt from the Saving Clause then general tax law principles will apply and not the treaty. Article 18 paragraph one (1) is not exempted from the Savings Clause — which means general tax principles apply. And, since the United States taxes Citizens and Lawful Permanent Residents on their worldwide income — the US would still take the position that it is taxable by the United States — although a Permanent Resident can still try to take the position that they have more significant contacts in Australia and should be treated as a nonresident for US tax purposes — and seek to avoid U.S. tax an US pension while a resident in Australia.
How to Claim Tax Treaty Benefits (Form 8833)
If a person qualifies under the tax treaty to avoid U.S. tax, it does not mean that they are exempt from filing a tax return. Rather, they would submit a tax return along with a Form 8833. Sometimes, if the Taxpayer had submitted a W8-BEN beforehand and the US plan administrator acknowledged and accepted the position — then possibly no taxes would have been withheld at source either.
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