How Are 401(k) Withdrawals Taxed for Nonresidents?

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How Are 401(k) Withdrawals Taxed for Nonresidents?

You may be deemed a nonresident alien if you are a citizen of Canada, Mexico, or another nation and sometimes live and work in the United States on a visa. The IRS defines a nonresident alien as a non-U.S. citizen who is lawfully present in the United States but lacks a green card or fails the significant presence criteria. As a nonresident alien, the IRS compels you to pay income tax solely on money earned in the United States.

Many nonresident immigrants who live and work in the United States prefer to invest in their American employers’ 401(k) retirement plans. However, when it comes time to return to your native country, this might be extremely difficult. Should you keep your 401(k) funds? Should you pay it out before leaving the United States or wait until you return to your native country? Should you transfer it to another account? And how will your 401(k) withdrawals be taxed if you leave the country?

Continue reading to find out how to handle this nonresident 401(k) problem.

Key Takeaways

  • The restrictions for early withdrawals from retirement accounts are the same for both US citizens and nonresident aliens.
  • Even if you are back in your home country when you take the money, the US will tax your whole 401(k) withdrawal as income.
  • If you are a nonresident with a 401(k) and intend to return to your home country, you may cash out the account, roll it over into an IRA, or keep the assets in place until you reach the age of 5912 and can begin taking penalty-free withdrawals.

Cashing Your Funds Out

The restrictions for early withdrawals from retirement accounts are the same for both US citizens and nonresident aliens. Participants in a standard or Roth 401(k) plan are not permitted to withdraw assets until they reach the age of 5912 or become permanently unable to work due to disability, according to the IRS.

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Beware the Early Withdrawal Penalty

If you are under the age of 5912, are not handicapped, and want to cash out your 401(k), you will be subject to a 10% early withdrawal penalty. So, if your 401(k) is worth $15,000 and you decide to sell it, you’ll have to pay an extra $1,500 in taxes. This effectively reduces your withdrawal to $13,500.

To top it all off, the US will tax your full 401(k) withdrawal as income, even if you are in your home country when you take the money. Because typical 401(k) contributions are made using pretax money, any withdrawn funds are included in your gross income for the year the distribution is taken.

Assume your marginal tax rate is 20% in the year you sell your 401(k) (k).This increases the overall tax effect for that withdrawal to 30% (the 10% early withdrawal penalty plus the 20% income tax rate).

As a result, if you withdraw $15,000 from your 401(k), you’ll have to pay a total of $4,500 in taxes, bringing your total take-home income to $10,500. This is why many financial consultants advise Americans not to cash out their 401(k) before they reach the age of 592.

The Delaying Game

A tax expert, on the other hand, may provide different counsel to a nonresident who plans to return to his or her native country. If you return to the United States and wait until the next tax year to cash out your 401(k), you will most likely fall into a lower tax rate since you will no longer be working and generating income in the United States.

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This might significantly lower the amount of income tax you owe on the 401(k) dividend. Remember that no matter where you reside when you cash out, you must still pay the 10% early withdrawal penalty if you are under the age of 5912.

Rolling Your Funds Over

Another approach to reduce your tax bill on a 401(k) withdrawal is to move the assets to another tax-advantaged account, such as an IRA (IRA).You will avoid the 10% early withdrawal penalty if you straight transfer your 401(k) to an IRA. To do this, you must first establish the IRA and then fund it with the 401(k) (k).

If you withdraw from your IRA before reaching the age of 5912, “you will still incur a 10% tax penalty, but you have more flexibility in terms of exceptions for avoiding the penalty, such as unreimbursed medical expenses, first-time homebuyer, disability, and so on,” says Mark Hebner, founder and president of Index Fund Advisors Inc., Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors.”

The Penalty-Free Withdrawal

For example, if you attend at least half-time, you may make a penalty-free early withdrawal from an IRA for qualifying higher-education expenditures such as tuition, books, and supplies for enrollment at an approved institution-plus a specific amount for housing and board as decided by your school. According to the IRS, certain foreign educational institutions engage in the Department of Education’s Federal Student Aid (FSA) programs. Check with the school first to determine whether it qualifies as an approved educational institution.

Keep in mind that IRA payments delivered to addresses outside the United States are subject to a 10% federal withholding requirement. Some financial institutions, however, may enable you to waive this withholding by submitting appropriate documentation. If you pick this option, your distribution will be governed by the treaty rate of your present nation. Treaty rates vary from 0% to 30%.

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The Home Country Option

After rolling your 401(k) into an IRA, you may move the IRA money to a retirement account in your home country.

Canadians, for example, may transfer their US IRA accounts to a Canadian Registered Retirement Savings Plan (RRSP).However, if you are a Canadian resident, you will be subject to a withholding tax in addition to the 10% early withdrawal penalty if you are under the age of 5912.

The Bottom Line

Residents and nonresidents are taxed equally on 401(k) withdrawals. If you are a nonresident with a 401(k) and intend to return to your home country, you may cash out the account, roll it over into an IRA, or keep the assets in place until you reach the age of 5912 and can begin taking penalty-free withdrawals.

“Although you are permitted to keep your money in the 401(k) until the age of 5912, the funds will be subject to your employer’s choices and costs,” explains Carlos Dias Jr., founder and managing partner of Dias Wealth LLC in Lake Mary, Fla. It is also worth noting that certain investment businesses are hesitant to have an investment account owned by a person who no longer resides in the United States.

Consider consulting with a financial adviser or a tax attorney before making this critical choice about your 401(k) withdrawals.

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