It is common for individuals to have pension accounts arising from a temporary work assignment and they are concerned with the U.S. withholding tax of 30%. They are also concerned about the 10% early withdrawal penalty.
Taxation of Distributions from IRAs and 401(k) Plans Under U.S. Federal Tax Law
Under the Internal Revenue, any distribution from a qualified plan such as an IRA or 401(k) plan that does not qualify as an eligible rollover-distribution is generally subject to mandatory income tax withholding. Although IRA and 401(k) plan distributions are subject to a 20% withholding tax, depending on the participant’s marginal tax bracket, the U.S. income tax assessed on the withdrawal could be significantly higher. In addition, Internal Revenue Code Section 72(t) imposes a 10% additional income tax on some distributions to individuals that have not reached the age of 59 ½.
The Effect of Income Tax Treaties
Tax treaties may provide an additional legal forum for the taxation of distributions from qualified plans. In certain cases, non-resident participants of qualified plans can reduce or even eliminate U.S. tax associated with a distribution from an IRA or 401(k) plan.
In order for a non-resident to utilize a tax treaty to reduce or eliminate the U.S. tax consequences associated with an IRA or 401(k) plan distribution, the non-resident must reside in one of 58 countries that have an income tax treaty with the United States.
What is the process of cashing out a 401(k)?
First tell the custodian that you want to withdraw your 401(K) and to provide you all necessary paperwork. Then make sure you fill 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 a copy of the Form 1042-S. Be sure to ask if form 1042-S or Form 1099-R will be issued to you.
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.
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 is FDAP income and it is subject to 30% tax rate. In this case, you may request partial tax refund
If you are not a U.S. citizen with a U.S. IRA or 401(k) and expect to depart the United States or have already departed the United States, contact us to discuss your options.