Should Foreign Nationals Participate in Your Company’s U.S.-Based 401(k)?

In the increasingly global economy, it is becoming more common that employers hire talented employees from every corner of the world. However, once your employees arrive in the United States and start working for you, questions about whether or not they should participate in your retirement plan may arise.

When we talk about foreign employees, it is first important to understand the various classifications – primarily Non-Resident Aliens and Resident Aliens. Resident Aliens are treated like U.S. Citizens for taxation purposes, while Non-Resident Aliens are treated differently. When designing their plans, sponsors have the option to exclude Non-Resident aliens from eligibility. However, because Resident Aliens are treated as citizens under the tax code, they cannot be excluded for eligibility purposes. Plan sponsors should carefully review their plan document to determine how foreign employees are defined and treated under the plan.

With regard to Non-Resident aliens, even if they are allowed to participate, they are usually in the U.S. for a shorter period of time, and in most cases it does not make sense for them to. 

Even though they are eligible, the most common question that is asked is whether Resident Aliens should participate in the plan. Here are some things to keep in mind when answering that question with your employee.

Each Employee’s Situation is Different

There are no universal rules for determining whether a foreign employee should participate in your retirement plan. It’s important to realize that how a participant’s account will be treated from a tax perspective depends on a number of factors, including:

• Whether the employee has a green card
• How long the employee will live in the United States
• The age of the employee
• An employee’s country of origin, the tax laws of that country, and that country’s tax treaties with the U.S.

While every employee should consider their own situation individually, generally most Resident Aliens will benefit from participating in a 401(k).

Taxes and U.S.-Based 401(k) Plans

Your employee’s country of origin probably has a tax treaty with the United States. Tax treaties from certain parts of the world are similar, but are not always exactly the same. As a result, it’s important for the employee to research whether or not the tax-deferred nature of the U.S. 401(k) will be honored later, after they return home.

While your employee is living in the United States, taxes are levied on their compensation, just like any other resident. Therefore, just like a U.S. citizen, contributing to a U.S.-based 401(k) can reduce the amount of taxes the employee pays.

Where it gets tricky is when your foreign employee withdraws money from the 401(k). Just as there are no differences in how contributions are handled for Resident Aliens versus U.S. Citizens, there are no differences in how distributions are taxed either. More specifically, distributions are taxed at the normal income tax rate. Further, if a participant takes a distribution before they are age 59½, an additional penalty of 10% will be charged.

Minimizing Taxes on Distributions

The most important part of a foreign employee’s interaction with your retirement plan will be when he withdraws his money. And here, patience is the name of the game. While it will be attractive for an employee to want to cash out his balance before he moves home, this can be costly for a few reasons.

First, assuming the employee didn’t move home on January 1, it’s likely that he had U.S. wages for that year. 401(k) withdrawals will be taxed on top of those wages. In addition, if the employee is not 59½, he will pay an additional 10% early withdrawal penalty. A better approach would be for the employee to leave the money either in the plan, or rolled to an IRA, and then draw that money down slowly after retiring. 

In fact, there is a way that your foreign employees can avoid all taxes on this money. There is a tax exemption for Non-Resident Aliens, which your employee would be the year after they move home.  Currently that exemption is $4,050. So if your foreign employee returns home, and is now considered a Non-Resident Alien, and then withdraws less than $4,050 per year, they can avoid taxes all together.

What About a Roth Contribution?

Roth 401(k) options are growing in popularity. This allows employees to take advantage of retirement savings that grow tax-free. Contributions are made after tax, and when withdrawals are made, they aren’t taxed.

Unfortunately for foreign nationals who move back home, this benefit might not transfer. Some tax treaties haven’t been updated to account for Roth accounts. This increases the chance of being double-taxed later. Therefore, in many cases, the traditional 401(k) contribution is a better choice.

What About Transferring Funds Between U.S.-Based and Foreign Retirement Accounts?

Depending on the tax treaty, it can get tricky to move funds between retirement accounts. If your employee’s country offers a tax benefit to the retirement account, there’s a good chance the status will be lost by moving it into a U.S.-based 401(k). It’s likely that the money would be taxed leaving the country of origin, and then the earnings would be taxed in the United States. Instead, it often makes sense to keep the accounts separate.

Consult with a retirement plan specialist as you help your foreign employees understand their options for retirement plan contributions.

Andrew Zito, AIF, is executive vice president, Retirement Plan Services of the LAMCO Advisory Services, an independent Retirement Plan Consulting and Advisory firm.