Foreign Pension

A foreign pension is a retirement arrangement created under the law of a country other than the United States, whether an employer plan, an individually held retirement savings vehicle, or a state scheme. The term is descriptive rather than statutory: US tax law has no single definition of a foreign pension and instead applies several general rules to it, which is why the treatment can look inconsistent from one plan to another.

The rule underneath all of it is short. Section 401(a) opens by confining qualified status to a trust "created or organized in the United States", so a plan whose trust sits abroad is outside the qualified-plan regime by geography alone. The favorable treatment a US worker takes for granted in a 401(k), meaning no tax on employer contributions until distribution and no tax on the account's earnings along the way, follows from qualification. A foreign plan that is generously tax-favored in its own country typically has none of it for US purposes unless a treaty supplies it.

The default rule: a nonexempt employees' trust. If a foreign employer plan is an employees' trust that is not exempt under section 501(a), section 402(b) applies. Under 402(b)(1), employer contributions "shall be included in the gross income of the employee in accordance with section 83", which means they are taxed when the employee's interest becomes substantially vested rather than when the money is eventually paid. Under 402(b)(2), amounts actually distributed or made available are taxable to the recipient under section 72, the annuity rules, so the amounts already taxed as contributions become investment in the contract and are not taxed twice. The practical effect is that the US taxes the plan earlier than the host country does, and the mismatch is the whole difficulty.

The foreign earned income exclusion does not cover it, and this is explicit in the statute. Section 911(b)(1)(B)(iii) removes from foreign earned income any amounts "included in gross income by reason of section 402(b)". So an American abroad who excludes their salary cannot also exclude the retirement contribution their employer made to the plan on top of it. That amount lands in taxable income at full rates in a year when there may be no cash to pay the bill with.

Income accruing inside the plan can be taxable before distribution. The IRS states the general domestic rule plainly in Rev. Proc. 2014-55, describing Canadian plans: a US citizen or resident who is a beneficiary of such a plan "will be subject to current U.S. income taxation on income accrued in the plan even though the income is not currently distributed to the beneficiary, unless the plan is an employees' trust within the meaning of section 402(b) of the Internal Revenue Code and the individual is not a highly compensated employee subject to the rule of section 402(b)(4)(A)." The revenue procedure adds the reason the problem is real rather than theoretical: the host country will not tax the accrual until distribution, so the two systems tax the same income in different years, and no domestic US relief fixes the mismatch.

What is inside the plan can be worse than the plan itself. Foreign retirement plans commonly hold locally domiciled pooled funds. A foreign corporation that is mostly passive is a passive foreign investment company for US purposes, and the default regime for one is punitive. Whether the PFIC rules reach a fund held through a particular foreign plan depends on how the plan is structured and on any treaty protection, so this is a question to ask about a specific plan rather than to assume either way.

The reporting stack has three separate layers. First, Form 8938. The IRS lists an interest in a foreign retirement plan or a foreign deferred compensation plan among the assets that must be reported when held outside a financial account, and the Form 8938 instructions draw the line that catches people out: a foreign government's social-security-equivalent benefit is not reportable, and that exclusion "does not include an interest in a foreign pension plan", which is. Valuation is the fair market value of the beneficial interest on the last day of the year, falling back to the value of distributions received and, where neither is knowable from readily accessible information, to zero.

Second, the FBAR, where the question is whether the arrangement is a financial account in a foreign country under the FinCEN rules rather than what the country of origin calls it. Third, the foreign trust reporting rules. Section 6048 requires annual reporting of a US person's transfers to, ownership of, and distributions from foreign trusts, on Forms 3520 and 3520-A, with penalties under section 6677. Section 6048(a)(3)(B)(ii) already excepts transfers to a foreign compensatory trust described in section 402(b), 404(a)(4) or 404A, which removes a large category of employer plans.

Rev. Proc. 2020-17 removed the foreign trust forms for a defined class. The revenue procedure exempts eligible individuals from section 6048 information reporting for "applicable tax-favored foreign trusts", a category that includes a tax-favored foreign retirement trust. To be one, the arrangement must operate exclusively or almost exclusively to provide pension or retirement benefits under the law of its jurisdiction, and satisfy several conditions, among them: it is generally tax-exempt or otherwise tax-favored there; annual information reporting on it is available to that country's tax authorities; "only contributions with respect to income earned from the performance of personal services are permitted"; contributions are limited by a percentage of earned income or subject to an annual limit of $50,000 or less or a lifetime limit of $1,000,000 or less; withdrawals are conditioned on retirement age, disability or death, or carry penalties otherwise; and an employer-maintained trust meets nondiscrimination conditions. Those two dollar limits are fixed figures in the revenue procedure and are not indexed. Only an "eligible individual", broadly one who is compliant or comes into compliance with the US income tax obligations related to the trust, may rely on it.

Two limits on that relief are stated in the revenue procedure itself. It "does not affect any reporting obligations under section 6038D or under any other provision of U.S. law, including the requirement to file FinCEN Form 114", so Form 8938 and the FBAR are untouched. And it is an exemption from a reporting requirement, not from tax: nothing in it changes how the plan's contributions or earnings are taxed.

Canada has its own long-standing route. Rev. Proc. 2014-55 sets out how a beneficiary applies paragraph 7 of Article XVIII of the US-Canada treaty to defer US tax on income accruing in a Canadian retirement plan until distribution. The election is made plan by plan, and once made can only be revoked with the Commissioner's consent. It is the clearest illustration of the general point: relief for a foreign pension usually comes from a treaty rather than from domestic law.

Treaties, and why they do not always help a US citizen. Many US income tax treaties contain a pensions article that can align the timing of taxation with the host country's, or preserve the deductibility of contributions. Whether such an article reaches a US citizen depends on that treaty's saving clause, which generally preserves the United States' right to tax its own citizens as though the treaty did not exist, and on whether the saving clause carves out the pensions article. Both vary treaty by treaty, so the answer for a German plan tells you nothing about a Japanese one, and a treaty-based return position is disclosed on its own form.

A foreign pension does not reduce your US Social Security benefit. For many years the Windfall Elimination Provision could cut a US benefit for someone who also drew a pension from work not covered by US Social Security, which included many foreign pensions. The Social Security Fairness Act repealed that provision along with the Government Pension Offset, so a foreign pension no longer causes that reduction. A separate mechanism, a totalization agreement, deals with cross-border Social Security coverage and credits, and is not affected by holding a foreign employer pension.

The order of questions is: what kind of arrangement is it under its own country's law; is it an employees' trust to which section 402(b) applies; is income accruing inside it currently taxable to the participant; what does the plan hold; which of the three reporting regimes reach it; and does a treaty change any of the above.

A hypothetical example of the timing mismatch. Sofia is a US citizen working in Germany for a German employer. Her employer contributes €6,000 a year to a company pension in which she is immediately and fully vested, for three years. Assume an average exchange rate of 1.10 dollars per euro across the period.

The plan is not a section 401(a) qualified plan, because its trust is not created or organized in the United States. Treating it as a nonexempt employees' trust, section 402(b)(1) puts the contributions into her gross income as they vest: €6,000 × 3 = €18,000, and €18,000 × 1.10 = $19,800 included on her US returns over the three years. Section 911(b)(1)(B)(iii) means she cannot cover that $19,800 with the foreign earned income exclusion even though her salary is excluded. What she gets in return is basis: the $19,800 becomes investment in the contract, so when the plan eventually pays out, that much comes back to her free of further US tax under section 72.

Germany, meanwhile, taxes nothing until she draws the pension. So her US tax arrives decades before her German tax on the same money, and the foreign tax credit is awkward to use because the two systems recognize the income in different years. The mismatch, not the total, is the problem, and it is the mismatch a treaty pension article is written to solve.

On top of the tax, she checks reporting. Her interest in the plan is a specified foreign financial asset for Form 8938 if her foreign assets cross the threshold. She checks whether it is a reportable foreign account for the FBAR. And she checks whether the plan is a tax-favored foreign retirement trust under Rev. Proc. 2020-17, which would exempt her from Forms 3520 and 3520-A while leaving the first two obligations exactly where they were.

Pros

• A foreign pension is usually a genuinely good deal in the country that created it, with local tax relief on contributions and often an employer contribution that would be irrational to decline.
• Amounts taxed early under section 402(b) become investment in the contract, so they are not taxed a second time when distributed.
• Rev. Proc. 2020-17 removes Forms 3520 and 3520-A for compliant individuals holding a tax-favored foreign retirement trust, which eliminates the single largest penalty exposure for many people.
• Where a treaty has a pensions article that survives the saving clause, it can align US timing with the host country's and make the plan work much as it does for a local colleague.

Cons

• The plan is not a qualified plan, so US deferral is not automatic and can be absent entirely.
• Section 402(b) can tax employer contributions as they vest, in years when the participant receives no cash, and the foreign earned income exclusion is barred from covering that income by statute.
• Income accruing inside the plan can be currently taxable to a US participant, producing a timing mismatch with the host country that the foreign tax credit does not cleanly resolve.
• Funds held inside the plan may be passive foreign investment companies, which carry their own punitive regime.
• Three separate reporting regimes can apply to one plan, with penalties that do not depend on how much tax is owed.
• Whether a treaty helps depends on that treaty's saving clause and its exceptions, so the answer differs country by country and cannot be generalized.