U.S. Taxation of Qualified Retirement Plans

Introduction

In general, the income taxation rules of pension plans in a domestic and international context and the payors withholding and reporting obligations upon pension distributions are complex. The complexity arises due to a disparity and confusion between the rules adopted by Congress in the Internal Revenue Code and treaties negotiated by the Treasury Department.

The purpose of this paper if to briefly describe the rules governing taxation of distribution from qualified retirement plans in a domestic and international context. Specifically the income taxation rules that apply to distributions from tax-qualified plans to U.S. Citizens and Resident Aliens (or “green card” holders), as well as distributions to Non-Resident Aliens. Moreover, the paper discusses the mismatches and complexities of the existing rules and the negative impact these rules pose from a compliance standpoint. Last, the paper suggests a potential alternative for taxation of, withholding and reporting of distributions from qualified pensions plan to foreign nationals that will greatly reduce administrative complications for the withholding agent, the recipient, and the Internal Revenue Service.

II. Summary of Taxation of Distributions From U.S. Qualified Retirement Plans in a Domestic Context

IRC Sections 401 provides that a “qualified” pension plan must be “created or organized in the United States,” and must be “for the exclusive benefit of “employees of their beneficiaries.” Thus, when an employer sets up a fund in a retirement fund that is for the benefit of its employees and/or the employees’ beneficiaries, and the fund is outside the reach of the employers’ creditor. Moreover, neither a participant in a qualified retirement plan is taxed ...

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...tributions to nonresident aliens (i.e., 30% flat rate or progressive U.S. individual tax rates on effectively connected income) from qualified pension plans. For example, as to funded U.S. qualified pension plans, a distribution bifurcated into (a) the contribution by the employer, treated as compensation, and the employee contributions to the plan, treated as personal services income, and (b) the investment return earned on the contribution either by the employer or the employee, treated as “earnings and accretions.” The contribution component is sourced to the place where the services were performed. Contributions made in connection with services performed in the U.S. are treated as “effectively connected income” and taxed at progressive rates. By contrast, contributions made in connection with services performed outside the U.S. are not subject to U.S. tax.