Do You Have a Foreign Pension or Foreign Trust?

Date March 29, 2024
Authors Inna Kisseleva Jelena Melnichenko

Have you worked overseas or moved to the U.S. from another country where you duly earned pension benefits or deferred compensation?  Do you also have a tax-free savings account or life insurance policy in a foreign country?  Your answer may be, “Sure, yes, but what does it have to do with foreign trusts?” That’s a valid question. After all, what do trusts have to do with pensions plans? Keep reading to find out more about U.S. taxation of foreign pensions and retirement accounts.

Migration among countries and continents has never been at levels in the history of humanity as high as today. We move seeking a better life, greater opportunities, and more freedom. Amid all this, taxation is not always a priority concern. Hence, tax is sometimes overlooked and falls through the cracks until a next deadline.

Most commonly, taxes on income from the likes of salaries and investments are remembered first. However, in addition to taxes on income items, the IRS requires the disclosure of foreign assets, including foreign pension plans and other deferred compensation arrangements.

Generally, foreign pension and retirement plans, including certain annuity plans, life insurance policies, and other tax-deferred savings accounts are treated as foreign grantor trusts.

What is a Trust?

In her article “Do You Have a Foreign Trust?” recently published in the Naples Daily News, Principal and Chair of the HBK Tax Advisory Group Amy Dalen defined “trust” as “any arrangement where an individual (trustee) holds title to property for the benefit of others (the beneficiaries).” A trust is defined as a “foreign trust” if a court outside the United States exercises primary supervision over the administration of the trust and no U.S. persons are authorized to control all substantial decisions of the trust. Foreign trusts can be grantor and nongrantor trusts. A trust is a grantor trust when a U.S. citizen is treated as the owner of the trust for income tax purposes. A nongrantor trust, on the other hand, is treated as a separate taxpayer from the grantor and beneficiary. The U.S. foreign reporting requirements differ substantially from other foreign trusts when a U.S. citizen is treated as the owner of either type of trust.

Trusts, Pensions, and Taxation

The IRS generally requires foreign grantor trusts to file two forms: Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts; and Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner. There are significant penalties, a minimum of $10,000, for failing to file complete and accurate Forms 3520 and 3520-A. The IRS can reduce or eliminate the penalty if the U.S. person can demonstrate reasonable cause for failing to file the required form(s).  

Now let’s turn to the role trusts play in defining pension plans. U.S. tax regulations distinguish between qualified and non-qualified pension plans. Consider a 401(k) as a qualified pension plan. Generally, a qualified pension plan is a trust created or organized in the United States and forming part of a pension plan of an employer for the exclusive benefit of their employees or their employees’ beneficiaries.1 By default, then, foreign pension plans are not qualified because they are not organized in the United States, the most significant difference being that contributions to qualified pension plans are deductible while distributions are taxable2.

Therefore, even though a contribution to a foreign pension plan is tax-deferred in a foreign jurisdiction, it could be taxed in the United States depending on the terms of pensions plan scheme. Moreover, since the U.S. person who contributed to the foreign plan is treated as the U.S. owner and beneficiary of a pension plan organized outside of the United States, the pension plan would generally be treated as a foreign grantor trust.

Thus, foreign pensions and other deferred-compensation accounts should be carefully evaluated by a tax advisor, as many plans can be treated as grantor trusts for U.S. tax purposes, bringing on a multitude of additional U.S. foreign reporting requirements. If such additional filings are not timely identified and complied with, the taxpayer may be subject to harsh penalties.

Furthermore, the investments held within a pension plan may also fall under the definition of Passive Foreign Investment Companies (PFICs). These are pooled investments that are registered outside the United States. Thus, in addition to Forms 3520 and 3520-A, the taxpayer might also be required to file a Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, for each PFIC held in the pension plan. Form 8938, Statement of Specified Foreign Financial Assets, and FinCEN Form 114, Report of Foreign Bank and Financial Accounts might also need to be filed. Each form carries hefty penalties for non-compliance.

It is important to know that the U.S. tax treatment of foreign pension plans can vary from country to country, depending on the tax treaty or social security totalization agreement between the United States and a particular foreign jurisdiction. 

Social Security System and National Pension Schemes

Government-sponsored pensions such as Social Security System or national pension schemes are public pensions. These are usually mandatory for all workers and funded by the employees, their employers, and sometimes governments. There are other characteristics that also need to be evaluated and depend on the country of origination. Where such characteristics exist, it is possible that even government-mandated retirement accounts can be treated as grantor trusts for U.S. tax purposes. However, it is also possible that a foreign government pension would have no specific reporting requirements in the United States until there are distributions. A careful analysis of the pension plan and tax treaty, if such exists between the countries, needs to be performed to determine treatment for U.S. tax purposes.

Employer-Sponsored Pensions

Foreign employer-sponsored pension plans are retirement plans that are established and maintained by employers for the benefit of their employees. The most common type of employer plan is a defined contribution plan. As with a U.S. 401(k) plan, foreign employer pension plans are generally funded by the employees while employer pension contributions may be either mandatory or optional depending on specific pension agreement and foreign country regulations. Unlike contributions to a 401(k) plan, no deduction is allowed for the employee’s portion of foreign pension contribution in the United States; it is treated as additional income for U.S. tax purposes. Furthermore, the employer’s portion of contributions may also be taxable in the United States in the current period.

Additionally, these plans are usually treated as grantor trusts for U.S. tax purposes, and therefore subject to foreign grantor trust treatment and potential PFIC reporting requirements.

Self-Funded Retirement Savings Accounts

Individual retirement accounts and retirement savings accounts are usually funded solely by the taxpayer. In absence of a tax treaty or other IRS-provided guidance, these types of foreign accounts are more likely to be classified as foreign grantor trusts for the U.S. tax purposes.  While this could be a tax-deferred plan in a foreign country, it is generally not in the United States where the foreign grantor trust is deemed an extension of a grantor. Hence, any income and growth in the plan is taxed currently. Just like foreign employer-sponsored defined contribution plans, these plans are subject to a myriad of tax filing requirements in the United States.

Other Financial Assets

Other financial assets that can result in foreign grantor trust treatment include tax-free savings accounts, certain types of life insurance policies, and other deferred compensation plans. If you are planning to immigrate to the United States, we strongly recommend pre-immigration planning to identify your potential U.S. tax reporting requirements. If you are a U.S. citizen or resident who has lived and/or worked in a foreign country, have pension plans or made investments in a foreign country, or even has family in a foreign country, you should speak with a professional familiar with international tax reporting to ensure you are in compliance with the U.S. foreign information reporting requirements.

HBK CPAs & Consultants can help you with planning and tax compliance. Please contact an HBK tax expert team for a consultation.

1IRC §401(a)

2IRC §§401(a), 402(b)

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