- In the beginning, there was Pillar 1
Your Swiss retirement rests in the hands of three pillars. We will begin by talking about the first pillar.
Switzerland’s social security system is usually referred to as Pillar 1 (or AVS or AHV). Salaries are taxed for Swiss social security just like the USA, but with a big difference: there is no salary cap on Swiss social security contributions. Do you make a million Swiss francs? You pay Swiss social security on a million Swiss francs.
Another difference between Swiss Pillar 1 and US social security is that the retirement age in Switzerland is 65 for men and 64 for women.
Suppose you are an American and you have worked in Switzerland for a Swiss employer for several years. In that case, you will be able to collect Swiss social security benefits when you reach retirement age, regardless of whether you retire in Switzerland or the USA.
- Moving to Switzerland temporarily? The Totalization Agreement may help you.
The US-Swiss social security treaty, also known as Totalization Agreement, allows US employers who transfer certain US employees to their Swiss branches for up to 5 years to cover them under the US social security system.
When the US employer does this, the transferred employee, now working in Switzerland, continues to pay into US social security and may continue to make 401k contributions during the first five years of Swiss employment. The advantage of this treaty benefit for short-term assignments is that it can help simplify the financial situation of the temporary assignee.
If the employee stays in Switzerland longer than five years, they must be localized. This means that they must start contributing to Swiss Pillar 1 and Swiss Pillar 2, which we will discuss in our next tip.
- No freedom in Switzerland: you must save for retirement!
In the United States, it is common for an employer to offer a retirement plan – giving the employees the option to participate. Participation is voluntary. Unlike the US, participation in Swiss employer plans is mandatory. Every employer must offer a retirement plan to their employees, and every employee must participate.
Employer pensions are commonly referred to as Pillar 2 plans. In a Pillar 2, both the employer and the employee contribute a certain percentage of the employee’s salary to the employee’s pension account. This percentage varies by age – the older the employee, the higher the rate of contribution.
- The return on your Swiss Pillar 2s contributions is guaranteed
Swiss law requires a minimum guaranteed return on employee and employer contributions made to Pillar 2 plans. As a result, Pillar 2 contributions are invested very conservatively. This minimum guaranteed return makes Pillar 2 great savings vehicles because the account balances never go down in value.
401k contributions, instead, can be invested more aggressively, and the employee accounts can go up and down in value due to changes in the value of the underlying investments. Over the long term, however, the more aggressive investments in a 401k will likely provide a higher rate of growth for the employee overall.
It’s essential for Americans living in Switzerland to understand that they will be contributing more to their Pillar 2 than they would their 401k, but they will see very little growth on these contributions.
Another vital difference between 401ks and Pillar 2s is that Pillar 2s must include an insurance component that provides insurance benefits to the participant in case of disability or the account heirs in case of death. In the USA, individuals would have to purchase this type of insurance privately as insurance policies are not allowed within 401k plans.
- What do you mean my Swiss Pillar 2 is not US qualified?
When you live and work in the USA, your employer’s retirement plan contributions are deductible from US income tax. The growth in the employee account is not taxed until the money is distributed at retirement.
Pillar 2s enjoy the same benefits in Switzerland: contributions are deductible from Swiss income tax, and the growth in the account is not taxed until distributions are made at retirement. Thus, most Americans expect the same tax benefits afforded to their Pillar 2 on the Swiss tax returns to be available to them on their US tax returns.
Unfortunately, that is not the case.
Swiss Pillar 2s do not meet the US tax code requirements to be considered qualified plans, and their contributions are not tax-deductible on the US tax return. Furthermore, employer contributions must be reported annually as taxable compensation! The income earned in the accounts is also usually taxable in the year the money was earned and it is not tax-deferred (an exception may be available to non-highly compensated individuals).
The different tax treatment of Pillar 2 contributions, growth, and distributions between the USA and Switzerland creates the risk of double taxation. However, with careful tax planning, US tax persons with Pillar 2 accounts can mitigate the risk of double taxation. Keeping track of their after-tax contributions and earnings on their Pillar 2 accounts can help reduce this risk. If you would like a copy of our Foreign Pension Basis Tracker, please request it by email to firstname.lastname@example.org.
- FATCA, FATCA, FATCA….FBAR, FBAR, FBAR: Do not forget to report your Swiss retirement accounts
FATCA stands for Foreign Account Tax Compliance Act, a law passed in 2010. It established the requirement to report specified foreign financial assets owned by US taxpayers if the aggregate balance of these assets exceeds certain thresholds.
Foreign pension accounts are specified foreign financial assets subject to reporting by their individual US owners. For example, suppose you are an American working in Switzerland with Swiss accounts with an aggregate balance above $200,000 by Dec. 31st of the year or $300,000 at any time in the year. In that case, you are required to report the balance of your foreign accounts, including your Swiss pension, on the FATCA Form 8938. In addition, if you are married to a US taxpayer, the filing threshold is doubled.
The penalty for not turning in Form 8938 starts at $10,000. Therefore, it is vital to keep track of foreign account balances to avoid penalties for failing to turn in Form 8938. Form 8938 is a separate and additional filing requirement from the FBAR Form FinCEN 114. The FBAR has a much lower reporting threshold: $10,000 in the aggregate, and failure to file can also result in an onerous penalty. Take these reporting requirements seriously, as the IRS has been paying increased attention to these forms and assessing penalties with regularity.
- Using the foreign earned income exclusion? Employer Pillar 2 contributions are not excludable.
As discussed in our Tax Planning Considerations video for Americans in Switzerland, the foreign earned income exclusion allows US persons living and working in Switzerland to exclude from US taxation a limited amount of earned income, typically wages or earnings from self-employment, from US income tax. The maximum amount of the exclusion gets adjusted annually for inflation, and in 2021 it is $108,700.
Remember how in Tip #5, we explained that Pillar 2 contributions are not US qualified, and they were taxed as compensation as a result? Well, many Americans may think, “No problem, I’ll just use the foreign earned income exclusion to exclude my compensation, including the contributions made to my Pillar 2.”
Not so fast!
The foreign earned income exclusion rules explicitly disallow the exclusion of employer contributions to nonqualified foreign pensions. These contributions must be included as compensation subject to income tax every year.
- Want to save more for retirement? Then, watch out for the Third Pillar.
Switzerland relies on three pillars to save for retirement: a First Pillar or Swiss Social Security, a Second Pillar or Swiss employer pensions, and finally, a Third Pillar or Swiss individual retirement accounts.
We rely on a similar system in the USA: US social security as the base, 401ks and other employer pensions as additional savings, and individually funded accounts or IRAs as personal supplements.
Many Swiss residents contribute to Third Pillar or Pillar 3 accounts to increase their retirement savings and reduce their Swiss income tax. You will likely receive recommendations from fellow Swiss residents to make Pillar 3 contributions as a way to save for retirement tax efficiently. However, as with Second Pillar or Pillar 2 accounts, contributions to 3rd Pillars are not tax-deductible on the US tax return. Thus, in many cases, US citizens who make Pillar 3 contributions reduce their Swiss income tax without an equivalent US tax reduction, limiting the contribution’s tax efficiency.
In addition to the potential tax inefficiency of Pillar 3 accounts for US citizens working in Switzerland, these accounts can carry high fees that reduce the growth potential and may also be invested in foreign funds, which are taxed as PFICs (Passive Foreign Investment Companies) on the US tax return. PFIC taxation is punitive and complex and can further erode the growth potential of Pillar 3 accounts.
For these reasons, making Pillar 3 contributions is not always a good idea for US persons living in Switzerland. Therefore, if you choose to open a Pillar 3, you should avoid investing in PFICs and consider different alternatives to meet this savings goal.
- Third Pillar or IRA? Know your choices!
If you are a US citizen with additional savings capacity, contributing to an IRA may be a better option than making contributions to a Pillar 3 account. Most US persons working in Switzerland are eligible to make US tax-deductible IRA contributions.
Unlike the USA, Switzerland generally recognizes IRAs as Pillar 3 equivalents and awards them most of the same tax benefits. Therefore, it is unlikely that your canton will allow you to take an income tax deduction for your IRA contributions. Still, it is very likely that it will exclude the balance of your IRA from Swiss wealth tax and that it will allow you to defer the taxation of the IRA growth until distributions are taken from the account.
Additionally, it’s generally relatively easy for Americans in Switzerland to open and fund IRA accounts with a US financial institution. As a result, the IRA contributions can be invested in US funds, such as US ETFs, not taxed punitively.
These benefits can make IRAs a more cost-efficient way to save for retirement than making Pillar 3 contributions for many Americans in Switzerland.
- Be ready for some complexity at retirement
US expats quickly discover that living and working abroad makes their financial lives more complicated. Of course, things can get complex whenever we manage income and assets in more than one country and more than one currency. This complexity is one of the trade-offs that globally mobile families make in exchange for the experience of living abroad.
If you live and work in Switzerland and contribute to Swiss First, Second, and potentially Third Pillars, you will need to deal with the distributions from those accounts when you return to the USA or retire in the USA. In addition, if you remain in Switzerland and retire there, you will need to handle the additional complexity of retiring in Switzerland with US income and assets.
When you do this, keep in mind that the USA and Switzerland are good economic partners and have treaties to help you maximize the benefits of having worked and lived in both countries. These treaties are your friends.
The US-Swiss Totalization Agreement will help you streamline benefit claims when you contribute to both Swiss Pillar 1 and US social security. However, be aware that your US social security benefits are likely affected and reduced by the Windfall Elimination Provision. On a more positive note, if you are married to a Swiss citizen, your Swiss spouse will probably be eligible for US social security benefits, even if you retire in Switzerland.
Regarding income taxes at retirement, the income tax treaty between Switzerland and the USA provides stipulations for the taxation of Second and Third Pillar distributions and the taxation of social security benefits received from the other country.
Living and working in Switzerland can be a fantastic experience, and many lucky Americans take advantage of this opportunity every year.
Building wealth for retirement in two different countries and managing two other systems can be complex and sometimes frustrating. The US and Swiss systems have similarities but also their share of differences. This can sometimes be perceived as a conflict, but there is always an opportunity in a challenge. The more conservative nature of the Swiss system can complement the more risky nature of the American retirement system. By combining the attributes of both, US persons who move to Switzerland can build a more solid foundation for retirement.
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This commentary is provided for informational and educational purposes only. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. To the extent that this material concerns tax matters, it is not intended to be used by a taxpayer as tax advice. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. Dynamic Wealth Advisors does not provide tax advice or services, Marina Hernandez offers tax preparation services under MHTax, this is considered an outside business activity from Dynamic Wealth Advisors and is separate and apart from Ms. Hernandez’s activities as an investment advisor representative of Dynamic Wealth Advisors.