Each year, over 200,000 people get a visa to work in the United States. Foreign nationals may be able to invest their savings in a tax-deferred 401(k). Their contributions may lower their taxable income for the year, and their employer might match a portion of the contributions. These immediate benefits could be attractive (everyone likes to save money!), but as a foreign national you might also be hesitant to tie your money up in a U.S.-based account.
There’s a lot to consider when you’re thinking about contributing to a 401(k) while working here on a visa. Hui-chin Chen, a CFP® with Pavlov Financial Planning in Arlington, Virginia, recommends starting by understanding the taxes that the country you return to may apply to your 401(k) withdrawals. She also suggests learning about tax treaties between the U.S. and that country.
This article reviews a few additional things that you should consider before making the decision.
Taxes and penalties on early 401(k) withdrawals
Withdrawing money from a traditional 401(k) may result in owing the U.S. government money. Regardless of whether or not you’re a U.S. citizen, when you make a withdrawal before you turn 59 ½, you could have to pay income taxes on the amount you took out.
There’s also a 10 percent penalty on unqualified withdrawals. Being over 59 ½ is one way to qualify, and you can also avoid the penalty if you become permanently disabled or qualify based on another hardship exception.
Where will you be in the future?
You may have a plan to work in the U.S. for several years and then return home, or you may want to settle down in the U.S. for the rest of your life!
If you think you may want to stay in the U.S.: You can use the 401(k) as it’s designed to be used. You could contribute now for the tax benefits and possible employer match, and withdraw the money after you reach 59 ½ or if you qualify for a penalty-free early withdrawal.
If you don’t see yourself staying or returning to the U.S.: It may still make sense to make contributions: it's possible that your plans might change. But, you could also wind up with more money when you return home if you make contributions during your time here.
Whether or not you come out ahead can depend on how you withdraw the money, your investment returns, and if your employer offers a contribution match. Before jumping into the numbers, you may also want to consider how the IRS categorizes you based on your residence.
Filing federal income tax returns for resident (green card) and nonresident aliens
Your income for the year, the source of the income, tax treaties between your home country and the U.S., and your status as a resident or nonresident alien can all affect how much you owe in income taxes to the U.S. government.
You’ll be a resident alien for tax purposes if you have a green card (in other words, if you're a permanent resident) or if you pass the substantial presence test.
Here's a quote from the IRS site:
To meet this test, you must be physically present in the United States (U.S.) on at least:
- 31 days during the current year, and
- 183 days during the 3-year period that includes the current year and the 2 years immediately before that, counting:
- All the days you were present in the current year, and
- 1/3 of the days you were present in the first year before the current year, and
- 1/6 of the days you were present in the second year before the current year.
They explain this in more detail and give an example case on their website here.
Resident aliens can claim the same deductions as U.S. citizens and use a Form 1040, 1040A, or 1040EZ to file a U.S. federal income tax return (more information from the IRS). Resident aliens may be able to claim personal exemptions for dependents and a spouse, claim itemized deductions or a standard deduction ($9,300 in 2016), and receive some of the same tax credits as U.S. citizens. These can all help lower your taxable income for the year.
To be considered a nonresident alien for tax purposes, you can’t have a green card nor can you pass the substantial presence test mentioned above.
As a nonresident alien, you’ll file a U.S. federal income tax return using form 1040NR or 1040NR-EZ. You may not be able to take the standard deduction (students and business apprentices from India are an exception), but you might be able to offset your income with a personal exemption worth $4,050 in 2016.
Remember: the rules for personal exemptions and deductions can vary for nonresident aliens depending on the tax treaties between your home country and the U.S.
Making 401(k) withdrawals as a resident versus nonresident alien
When you make an unqualified withdrawal from your 401(k) as a resident alien, the amount withdrawn is added to your income for the year. You may be able to offset the income with exemptions, deductions, or credits to decrease your effective tax rate. But, if you earned a lot from your U.S. employer, you could still be in a high tax bracket.
It may make sense to wait to withdraw money from your 401(k) until you’re a nonresident alien.
As a nonresident alien, if you make an early withdrawal from your 401(k) the money may be considered Effectively Connected Income (ECI). The ECI is taxed at the same graduated rates that apply to U.S. citizens’ income.
In other words, if your only income from the U.S. is the 401(k) withdrawal, you may be able to avoid U.S. federal income taxes by withdrawing $4,050 or less – the amount equal to your personal exemption. (The personal exemption may increase or decrease each year.) The 10 percent unqualified withdrawal penalty may still apply regardless of your residency status.
The 401(k) plan’s provider might withhold up to 30 percent of the money when making a disbursement to nonresident aliens. This doesn’t mean you’re taxed at a 30 percent rate, and you may be able to get the withheld money back when you file a tax return.
Comparing three withdrawal methods
With an understanding of the implications of taking early withdrawals and how your residency could affect your taxes, consider the different methods you may want to use to withdraw money from a 401(k).
Lump sum: You could decide to take the money out in a single lump sum, or series of smaller lump sums when you want it. The penalty will apply if the withdrawals aren’t qualified, but there could still be an overall gain.
For example, if your employer offered a 100 percent match, your $5,000 contribution would turn into $10,000. You’ll have to pay income taxes and a penalty, but if you withdraw the full $10,000 as a nonresident alien without any additional U.S. income you’ll still wind up with more than your original $5,000. Plus, you lowered your taxable income for the years that you made the contributions.
Rollover to an IRA: Once you separate from your employer, you may be able toroll over your 401(k) to an IRA. In some cases, you may not have any choice to withdraw the funds or make a rollover as some account custodians don’t service members that have a non-U.S. address -- be sure to check!
There could be several advantages to moving to an IRA. You may have more investment options if you want to change your investment allocation. There are also additional penalty-free withdrawal circumstances, such as paying for some higher education expenses. This may be a good option if you plan on returning or sending a child to the U.S. for university.
Periodic payments: Once you separate from your employer, you can take use the “72t” exception and take periodic, equal, and penalty-free withdrawals from your 401(k). You can also use this rule with an IRA while you’re an employee.
The withdrawals will be in monthly or annual distributions over your expected lifetime, as determined by IRS-approved life expectancy tables. There may bedifferent tax rules applied to these passive periodic payments than those for lump-sum withdrawals. Once you reach 59 ½, you can withdraw remaining funds penalty free.
There’s a lot to keep in mind when you’re deciding whether or not to contribute to a 401(k) as a foreign national. You may want to start by learning about tax treaties between the U.S. and the country where you’ll be living when you withdraw the money, as well as the tax implications and penalties that can result from 401(k) withdrawals.
If you’ll want to take the money out of the 401(k) as soon as you leave the U.S., it’s possible that you could still benefit from enrolling in the plan. Depending on your employer’s matching program, and your tax bracket while making contributions versus withdrawals, even after paying income tax and a penalty you could wind up with more money.
Sources and additional resources:
- Non immigrant Visas Issued by Classification (U.S. Department of State)
- Tax Attributes of Specific Visas (J.Allis&Co.)
- Aliens - How Many Exemptions Can Be Claimed? (IRS)
- How to Report Income on Form 1040NR (IRS)
- Foreign Employment Contributions While a Nonresident Alien (IRS)
If you want to set up or switch to an a 401(k) that's great for employees and employers, let your company know about Human Interest.