JLP over at AllFinancialMatters has a post where he addresses a question about early withdrawals from a 401(k) plan. The person who asked the question is planning to return to India in a few years, and wonders whether it is worth contributing to his 401(k) plan at work. He stands to gain from the tax-deduction, tax-deferred growth and employer match, but may be subject to taxes and a 10% penalty for early withdrawal.
Concerns of this sort prevent many expatriates and immigrants from taking advantage of the best avenues available for investing for their future. Consider the complications involved in this situation:
- If the person is a permanent resident (green card holder) when he leaves America, it is easy to address the question of Federal taxes. One can use a phased withdrawal approach to minimize taxes. The idea is to withdraw only enough money each year to reduce the impact of taxes upon withdrawal. It is also possible to reduce the 10% penalty for early withdrawal by rolling over the 401(k) to an IRA and then converting to a Roth IRA, subject to the restrictions for IRA rollover and Roth conversions.
- However, what may end up costing him more is taxes due in India. India taxes its residents on their worldwide income, and a distribution from an IRA counts as income for him. Depending on his tax bracket in India, this can be quite expensive.
- On the other hand, India provides a special "semi-resident" status for those who worked abroad and returned to India. When in this status, income from foreign sources, including distributions from retirement plans, are not taxed. Unfortunately, this status lasts only for a few years, so any phased-withdrawal strategy will have only a limited benefit.
- For most people then, the best strategy may be to just leave their money in the 401(k) account, if this is allowed, or to roll over to an IRA and leave it there until they reach retirement age. Many IRA custodians, such as Vanguard and Fidelity, allow non-citizens to maintain their IRAs even if they are no longer living in the US. Nowadays, it is quite easy to manage these accounts online from anywhere in the world.
- The above options, however, may not work for someone who is not a permanent resident (i.e. does not have a green card) when he leaves the US. This is because there is a flat 30% federal tax on IRA distributions to non-resident aliens. Even worse, the IRA custodian is required to withhold this 30% when the distribution is made. This harsh penalty may severely limit any benefit gained through tax-deferred growth and employer match on the 401(k) contributions.
This situation illustrates the kind of problems that prevent expatriates and immigrants from planning for their financial future. Faced with the uncertainties, many of them don't bother with their employers' retirement plans at all. This is unfortunate, because most of them end up staying in America longer than they ever planned on, and many never leave. For them, not contributing to the 401(k) would be a huge wasted opportunity.