Early 401(k) withdrawals for non-citizens

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.


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27 comments:

Prasanth said...

Nigel,

Exactly the issue I'm faced with. I'm not a permanent resident and will go back to India in another 4 years or so. I cannot invest in an IRA , 401 K etc because of the penalties. My company does not offer a 401 K anyway. What hurts is the Social Security that is deducted from my salary when I know that I will never be able to get any benefit from it.

Regards,
Prasanth

Ramesh said...

Nigel,
great blog there. exaclty the topics I had been looking for. I have the same thoughts about 401k, but was not aware of the 30% penalty.
Prashanth, I remember reading somewhere that if we are permanently moving back to India we can recieve a refund of the social security that we pay in H1B status. I am not very sure though. Anybody, any idea??

Nigel said...

There is currently no treaty between US and India on social security benefits (see here for a list of countries that do). There are some efforts (see here) to get such a treaty in place. I think this is quite likely sometime in the future, so there is a good chance that your contributions will not be lost. I don't think a simple refund is likely, though.

John said...

Nigel,

Excellent Blog - Thank you.

A comment/question on the IRA-Roth IRA conversion strategy: My understanding is that the conversion itself is not a taxable event in India - only the realized accruals on your retirement accounts (after RNOR period) are taxable. So, the periodic conversion strategy with the actual amount determined so as to fall just below US standard deductions etc. (~20-25K/year depending on family size etc. per current US tax table) seems very viable to minimize taxation during conversion once you retired in India. Then, by the time you are ready to withdraw (hopefully later than age 59.5 to avoid 10% penalty), all your retirement accounts will be after tax and so no US taxes due. The obvious benefits are: a) protection against future US tax increases in the future which may be very real given the deficits, and b) Social Security (assuming it is available) income will cause your realized income to go up and so have this after tax dollars allows minimizing other income realization that can cause tax rates to go up. Do you have information to corroborate the above? If so, please share.

Once you retire, one good strategy might be to try and minimize income realization. To that end, AAP with an eye toward minimizing income realization while not negatively impacting liquidity might be good overall. So US growth stocks or mutual funds (minimal income realization assuming not much dividends), Indian growth stocks (same as US growth stocks with emerging market exposure and dollar hedging), land/plots in India (negatives are liquidity and possibiliy of 1%/annum wealth tax 7 years down the road once in India), US/Indian rental properties (negatives are liquidity, management issues & income realization), US Bonds (negative is income realization), Indian Stock/Bond mutual funds (negatives are income realization and IRS PFIC rules) in that order might be good to consider for AAP.

Regards,
John.

Nigel said...

John,
Your observations are right on the money. I was planning to write about some of the topics you mention. Roth conversion is a strategy I have seen recommended in several places for minimizing US taxes for early retirees. I am not knowledgable enough about taxation in India, though. Your comments about asset allocation also sound very reasonable.

John said...

Nigel,

Thanks for the response.

Look forward to reading more of your insights on minimizing taxation for early retirees, Roth conversion, AAP, etc...

kedar said...

Hi

Can anyone correct me, if my understanding is wrong for early withdrawals of 401k for non-citizens, Like L1 or H1 visa holders.

My understanding is Early withdrawals if employer matches equally to employee contribution still works out 180% ROI after penality and taxes. Example
Employee Contribution 200.00 200.00
Tax saved 30% 60.00
Net Out flow 140.00
Employer Contribution 200.00
401k Contribution 400.00

Early withdrawal
10% Penality (40.00)
30% Taxes (108.00)
Total Deductions (148.00)
Net Inflow 252.00
ROI in Percentage 180.00

Nigel said...

Kedar,
I think your calculations are not far off, assuming that you are in the 30% tax bracket now.

There are not many employers that provide a 100% match -- something like 50% match for up to 6% of your salary is more typical. If your employer does provide a 100% match, it is worth considering.

A more accurate comparison would be to compare the 401(k) with a taxable account, where you may have a lower tax rate for earnings from dividends and long-term capital gains.

Sri said...

Nigel,
I am on L1 visa and will be here for one more year before returning to India. I opted for 401K thinking that I would roll over to IRA when I leave to India. I like to leave it with either vanguard or Fidility till i reach 59 1/2 years. I am confused if it is beneficial to continue 401K. Could you please clarify?

Nigel said...

Sri,
It may be worth contributing just enough to get any employer match. Beyond that, it depends on how comfortable you are with leaving your money in an account that you cannot withdraw from (except with a 40% tax/penalty).

Sri said...

Thanks Nigel. I appreciate your effort to reply me. I find income tax law in US is as complex as India

nickienick said...

Hi Nigel,
Great job writing an extensive blog on such an important topic for so many people. I have recently started looking at 401k/IRA options so my questions are of the novice category.

I have a quick question about rolling over 401k to Traditional IRA & then to Roth IRA. Is there a specific time when one gains more from rollover from 401k to Traditional IRA...for example when you are changing employers or after you get a full match from your employer etc or can one keep it the 401k as long as one wishes without losing on any benefits.

Also, what is the ideal time, if any, at which point one should go for Traditional to Roth Conversion, considering the statement you made in one of your articles, "income is likely to be lower during early retirement years, it would be an ideal time to convert your Traditional IRAs to Roth IRAs."

Nigel said...

nickienick,
Thanks for your comment.
You can roll over your 401(k) to an IRA anytime after you leave the job. If you are not happy with the investment options available in your 401(K), you'd want to do this as soon as you leave the job. This is because you'll normally have more/better options in an IRA. Your employer may have specific restrictions on rollovers, so it is important to check with them.

About converting a traditional IRA to Roth, you can think of the money being converted as additional income to be added on top of any taxable income you have for that year. (This is because this is money that has not been taxed before). So if you are in a high tax bracket for the year, you'd be paying taxes on this money at a higher rate. If you have some years when your income is expected to be low (due to going back to attend college full-time, or taking early retirement, for example), you'll be in a low tax bracket and you'll be paying less in taxes on the converted amount.

nickienick said...

Hi Nigel,
Thanks for the response. Based on what you said about the IRA to Roth conversion being additional taxable income, is it possible to convert an IRA ccount to Roth in a phased manner over multiple years so as to keep the total taxable income within a certain income bracket? Or does an IRA when converted has to be converted 100% and tax when converting is pretty much unavoidable unless your annual income is low due to unrelated circumstances?
Regards
n!

Ravi said...

Nigel,
This is the same issue i am facing now. I am contributing to my 401K with 50% match from the employer. I am planning to go back in 2/3 years. Can I rollover my 401K into traditional IRA before I leave and the next year (When i am in India) rollover the same to Roth IRA. In this case, do I have to pay taxes on the amount that is moved from TRaditional IRA to Roth IRA. In that year, i will be in india and I should fall in the lowest tax bracket. Will this work?

Nigel said...

nickienick,
You can do a partial conversion. Although it is called a "conversion", you are really moving money from one account to another, and you get to choose how much to convert.

ravi,
This strategy should work if you are a US citizen and are filing taxes as a resident. If you are a nonresident, your IRA custodian should be able to tell you if there are any special restrictions. You may also be subjected to taxes in India on this amount, so the exact outcome of this depends on many variables.

Prithvi said...

Hi there, great blog. There has been a lot of discussion about early roth withdrawal. What about taking a distribution after the age 60? Is there a tax on that money if you aren't in the country or does India allow you to take the tax free distribution? Thanks,

Nigel said...

prithvi,
There are no US taxes on qualified withdrawals from a Roth, whether or not you are in the country. Some IRA custodians may withhold a portion if you are not a US resident, but you should be able to get it back when you file your tax return.

Indian tax situation is less clear. According to the dual taxation avoidance agreement between India and the US (DTAA), India doesn't tax social security or "public pension" payments from the US, but will tax "private pension" payments. The status of 401(k)/IRA accounts is not clear, but it is possible that it will be taxed in India.

Unless you are close to retirement, I would not depend on this one way or the other, since the tax laws of both countries may change by the time you are 60.

Sunshine said...

This is a great discussion as I have barely found any information on the topic anywhere. I am leaving the US in a month to move back to India (H1B status-been investing in 401k for 2 years). My employer match is 25%.
I know I can continue keeping my money in the 401k (as long as it is more than 500$). What are my other options? Are there IRA's in india which you can transfer the money to? How does that work in terms of taxes and distribution? Or it is beneficial to just move it to an IRA here--also traditional/Roth?
Sorry I am a novice in these topics! Any help is appreciated.!
Thanks
Sunshine

Sunshine said...

Sorry I meant more than 5000$ (not 500)

Nigel said...

Sunshine,
Your options are 1) Leave it in the 401(k) if your employer allows it 2) Roll over to an IRA after you leave your job, but before you leave the US 3) Withdraw the money, and pay the taxes and penalty.
It is not possible to transfer the money to a retirement account in India.

The best option for you depends on what you want to do with this money. Options 1 and 2 will allow you to postpone paying taxes on them, but you may be subject to taxes and/or penalty when you withdraw the money.

Anonymous said...

Nigel,

Any idea if accruals (Cgains on MF sales or dividend payments) in the 401k account is taxable in India - i.e no withdrawls have been made. I am assuming that I keep my 401k after quitting my job and then move back to India.

Thaks
MD

Nigel said...

MD,
I have heard that according to a strict interpretation of Indian income tax rules, you have to pay taxes on "accruals" in foreign retirement accounts, which would include interest/dividends/capital gains earned in 401(k) accounts even if you do not withdraw any money. I find this unreasonable, and have not yet personally heard about anyone who actually paid such taxes in India. I don't know of any way this can be enforced, since 401(k) administrators do not have to provide this information to IRS, let alone to non-US tax authorities. I have yet to see any official word on this.

By the way, for most people it is better to roll over the 401(k) to an IRA if you are leaving the country, since you will usually have better investment options there.

Kish said...

Hi Nigel,

Great effort. Really appreciate it.

I am facing a 'filing issue'. I already took full distribution form my 401K account. Fidelity did not withhold any tax and gave me entire amount on the reasoning that India has a Tax treaty with US and I am solely responsible for paying tax. They did not even deduct the 10% penalty that I was ready to pay for.

I received a 1042-S with income code 14 and exempt code 04. I am not sure how to pay the tax. Should I pay it in my Indian filing, or should I file 1040NR? Or do I have to do both and take a tax credit in US filing?

1040NR (2007) instruction for line 17 says I should include income showed in 1042-S. If I do so, the tax rate from the tax table applies and the tax rate becomes 19.7%.

* Then how is it flat 30% tax?
* How do I pay the penalty?
* Do I have to pay CA state tax too (my earnings happened in CA)?

I am not finding any IRS publication which clearly says nonresident aliens should do 'this, this, this, and done'. I consulted pub 519. From all the publications it seems that I just have to fill up 1040NR and show the 1042-S inclome in line 17b. That's it as far as 1040 goes. I still do not know how to pay the 10% penalty, and if I have to pay tax to CA through 540NR.

Please help me if you can. In this confusion I already crossed due date of US tax filing. I am a law abiding individual and do not like to keep taxes due.

With Best Regards,
Kish

Anonymous said...

Nigel,

lovely blog, bad I didn't find it before. I have just moved to US and no nothing about US investment/ retirement scene. I am writing this on behalf of my husband.He has opted for 401(k) with 25% employer contribution. There is a possibility that we'll leave US in another 7-8 years.

Option 1: On leaving the job and before leaving US convert 401(k) to IRA and then IRA to ROTH IRA.

a.How does this work to save taxes??


Option 2:

Anonymous said...

Option 2: If he continues to keep the money in US, till retirement and withdraws later, when we are in India-

a. There won't be any tax issues in US, if he's still, at the retiring age filing return as US resident, or there wont be any tax issues at all, whether he files a return or not.

b. India would be taxing any appreciation to the fund, but what when the fund is withdrawn completely.

MY said...

Great Blog.. Really a rare info found no where.. thanks for your constant update Nigel.

Here is my question..
a. What is the meaning of Tax Credit that is shown in Social Security Statemenent. One of my friend said if I get 40 tax credits I will get some money (like pension) after my 59.5 years.. is that true...