In our blog post IRS Tax Relief for U.S. Taxpayers with Certain Foreign Pensions I wrote:
Before anyone goes rushing into investing in a Pillar 3 or other individual foreign pensions, though, one final comment about PFICs. Swiss ETFs or mutual funds, and other foreign investment funds that are the typical investment vehicles used in foreign individual retirement accounts, are generally classified as PFICs for US tax purposes. PFICs are taxed punitively and have extensive filing requirements of their own, and this Rev. Proc. provides no relief from those PFIC requirements.
My comment was specifically about Pillar 3as, which are type of Swiss individual retirement accounts, but the concept applies to any non-qualified foreign pension that it is not an employees’ trust: If you are a US taxpayer and you have a non-qualified foreign pension that is not an employees trust, you may have a PFIC issue.
Confused? Let’s break this down.
When is a foreign pension a non-qualified pension?
I like to look at this starting from the basics. First, the pension must be foreign. If a pension is foreign, you must understand the default assumption. This is key. What is the default assumption for foreign pensions? The default assumption is that they non-qualified.
Simple. If you have a foreign pension, odds are, it’s non-qualified.
As you may have assumed, a qualified pension is better than a non-qualified pension. Why? Many reasons, but the one that matters to us today is that qualified foreign pensions don’t have to worry about PFICs.
Is qualified better than non-qualified?
Qualified pensions have certain benefits. Certain superpowers. One of those superpowers is that their investments are not treated as PFICs. Even if they otherwise would be PFICs. By virtue of being qualified, the pension income is automatically treated as regular income, therefore losing its PFIC character.
To be qualified, pensions need to meet certain legal requirements. And to meet any legal requirements, the first thing you need is a law. In the case of US pensions, that law is our Internal Revenue Code, most commonly known as the Tax Code. In the case of foreign pensions, that law is an income tax treaty between the USA and the foreign country where the pension was established.
Is your foreign pension from a country that does not have an income tax treaty with the USA? Look no further, your pension is non-qualified.
Is your pension from a country with an income tax treaty with a USA? You pension MAY be qualified.
Why just MAY?
Because unfortunately, many tax treaties don’t provide comprehensive pension benefits.
Examples of treaties with comprehensive pension benefits include Canada and the UK. There are others, but Canada and the UK are the most comprehensive.
Examples of treaties with limited pension benefits include, you guessed it, Switzerland… and Spain, Portugal, Mexico, Australia, and unfortunately most countries with which the US has an income tax treaty.
Conclusion: unless you have a UK, Canadian, Dutch, German or perhaps a Belgian pension, your pension is probably non-qualified. If you are not sure, you may need to ask a professional.
Can a non-qualified foreign pension be an employees’ trust?
Is that a good thing?
Because employees trusts have a similar superpower that qualified pensions have: they make PFICs disappear! If your foreign pension is an employees trust, it doesn’t matter that it is non-qualified and it doesn’t matter how it is invested. It does not matter if it has foreign mutual funds.
It. Does. Not. Matter.
Unlike qualified pensions, the income earned annually is probably taxable, but it is not taxable as PFIC income, it is taxable as plain ordinary income. And plain ordinary income is, in the vast majority of cases, taxed a lot better than PFIC income.
How can I know if my foreign pension is an employees’ trust?
These are three things you should consider:
- Your pension must have been established by your foreign employer. This automatically eliminates individual foreign pensions. If the foreign pension was opened by you, the US taxpayer, with your own money, your pension is NOT an employees’ trust.
- Your pension must be managed by your foreign employer or by a pension fund manager hired by your employer that provides this service to your employer. If you can choose the pension manager, your pension is NOT an employees’ trust.
- Your employer contributed AT LEAST half the money in your foreign pension account. You are allowed to make contributions from your salary, but 50% or more of the total contributions need to come directly from your employer. If you contributed more than 50% of the total contributions made to your foreign pension account, your pension is NOT an employees’ trust.
In summary, your foreign pension needs to have been established by a foreign employer, managed by it or by a pension manager selected by it, and funded mostly by your employer’s own money and not with a portion of your wages, in order to meet the requirements of an employees trust.
If you have an employees’ trust, you avoid the PFIC issue.
What if your pension is non-qualified and it is not an employees’ trust? Then we circle back to the question that got you reading this post.
What is a PFIC and why should I care?
Foreign pensions need to make the money grow for their participants. The value of the account needs to grow so there is money for you to draw from in your retirement. In order to achieve growth, foreign pensions invest their money. And because the pensions are in a foreign country, they will likely invest it in mutual funds and ETFs registered and regulated in that foreign country, i.e., PFICs.
PFIC stands for Passive Foreign Investment Company: in simple terms, foreign companies that make passive investments. Passive investments include rental income, income from copyrights (unless you are the artist that generated the copyright), dividend income, capital gains from stocks, interest from bonds or mortgages, etc.
The most common types of PFICs are foreign mutual funds and foreign exchange traded funds (ETFs).
What’s the big deal with PFICs?
Each foreign mutual fund or ETF is a separate PFIC. Foreign pensions are typically invested in multiple foreign funds, so you will likely have multiple PFICs in each of your foreign pensions.
Each separate PFIC requires its own PFIC tax return, Form 8621. Yep, you will need to file a 6 page tax return per FUND in your foreign pension. Retail tax preparation software does not generally carry this form, so you can’t use it to prepare and report your PFICs. You will either need to download the forms from the IRS website and complete them manually (not recommended, the calculations are complex and chance of error extremely high!) or you will need to hire a professional to do it for you, which will NOT be inexpensive.
To top it off, PFICs are taxed punitively. There are three different ways in which PFICs can be taxed, but mostly, they are taxed under Mark to Market, or MTM rules, or the default Excess Distribution Rules. As most default taxation rules, the Excess Distribution Rules are usually the most punitive.
Punitive = you pay a lot more tax than otherwise.
What are some of the bad ways in which PFICs can be taxed?
- Reduced rate qualified dividend treatment is not available under the MTM and Excess Distribution rules. Dividends are always taxed at ordinary rates and potentially at the highest ordinary tax rate.
- Reduced long term capital gains tax rates are also not available.
- Under the default excess distribution rules, there is an additional interest charge on top of the highest marginal tax rate applied to the income. The effective tax rate can therefore exceed 50%!
- Unlike with US ETFs and mutual funds, where losses in one fund can be netted against gains in another fund and only the net gain is taxed, PFIC losses cannot be used to offset gains in a different PFIC. The loss is suspended, and the gross gain is taxed in full.
If your foreign pension is non-qualified, it’s not an employees’ trust and it holds foreign investment funds, you have to deal with the PFIC rules.
Beyond the additional cost of having to prepare and file a Form 8621 tax return for each PFIC in your foreign pension, the PFIC income will typically be taxed at a much higher rate than otherwise. It could even be taxed at rates that exceed the highest marginal US tax rates when there is also a PFIC interest charge.
These extraordinary costs can eat up the income provided by the PFICs and then some, and as a result, drastically reduce the benefits of saving for retirement through a foreign pension.
My example was about Swiss Pillar 3s. Pillar 3s have similar contribution limits to traditional IRAs, therefore these accounts are rarely large. The reporting cost can be relatively high due to the small size of the account, and can exceed multiple times over the investment income earned by the PFIC.
Swiss Pillar 3s are tax deductible in Switzerland. If the Swiss marginal tax rate is higher than the US marginal tax rate, the Pillar 3 will likely reduce the combined income taxes of the Pillar 3 participant. This situation can occur with high-income earners in certain Swiss cantons, especially after the US tax rates were lowered by the Tax Cuts and Jobs Act in 2018.
However, if the Pillar 3 investment horizon is long enough, the recurring PFIC reporting and tax cost can more than offset any tax savings provided by the Pillar 3 contribution.
The tax savings are a one-off event. The cost of PFIC reporting and their punitive taxation is a recurring annual expense.
These are just the pure tax cost considerations.
Many other considerations come into play in the decision to participate in a foreign pension, whether sponsored by an employer or not. Sometimes you may not even have a choice about it and you’ll just have to deal with US tax consequences. Do not lose sight of this and don’t let the tax tail wag the dog. There are situations when a foreign pension makes sense despite potential onerous US taxation.
Before signing off, the usual disclaimer: this is not legal tax advice intended for anyone in particular. This is general information to help you understand how to think about things. Do not rely on this information to draw any conclusions about your situation and your specific foreign pension. If you do so, understand that you are doing it at your own risk and that you may reach the wrong conclusion.