If someone later becomes a non-resident alien, how are Traditional/Roth 401(k)/IRA withdrawals taxed? E.g., can NRAs withdraw Roth principal tax-free? How about earnings?

[joywyx0]

I’m currently a resident alien and have both Traditional and Roth 401(k) accounts. I’m considering whether it would make sense to convert them to IRAs before potentially becoming a non-resident alien in the future. I’ve seen some guidance suggesting a 30% tax, but it’s unclear whether this applies to principal, earnings, or both. This seems higher than the tax rate if I invest directly through a brokerage account, so I’m a bit confused. Given that in the future—e.g., 1–2 years—I might be an NRA, specifically, I’d like advice on: 1. Should I continue contributing to my 401(k)? If so, should it be Traditional or Roth? 2. If not, when would be the best time to transfer my existing 401(k)s to an IRA? Should I transfer to a Roth IRA, or just move the Traditional 401(k) to a Traditional IRA?

[pk]

@joywyx0 , do you still need help on this ?   Please note that  there is a need to know which country you would be a citizen/Resident of once you attain US NRA status.  Also how long would you have been a Resident of USA by that time --- you may need "sailing permit"  ( essentially a tax settlement  ).

Look forward to hearing from you 

[Opus 17]

In general, NRA's are taxed only on US-sourced income, using form 1040-NR.  401(k) withdrawals are considered US-sourced, because you were working in the US when the contributions were made.  That means you should expect your withdrawals of Roth-401(k) funds to be non-taxed and withdrawals of pre-tax 401(k) withdrawals will be taxed by the US even if you are an NRA.

Whether any of these withdrawals are taxed in your home country will depend on their laws. 

Yes, there is mandatory 30% withholding on your taxable 401k withdrawal if you are an NRA, this is to encourage you to file your tax return, and you will get a refund if the actual tax is less than 30%. 

I'm less clear about IRAs, but they seem to be considered taxable as FDAP income (Fixed, determinable, annual, or periodical income).  Same 30% rule applies.

Of course, any tax treaty may modify these general rules, so it is important to know the country you are asking about.  

[joywyx0]

Thank you for clarifying! In my case, the country is China. Could you please let me know how the U.S.-China tax treaty may modify these rules?

[joywyx0]

Hi!

Thanks for your previous explanation — I have a couple of follow-up questions for clarification:

1. Regarding Roth 401(k):

   • For RAs, I understand there’s a distinction between qualified distributions (account ≥5 years + age ≥59½, including earnings) and non-qualified distributions. Qualified distributions are non-taxed. And non-qualified distributions haveRA Ordinary income tax + 10% penalty (unless exception) 

   • For NRAs, it seems qualified distributions are non-taxed. Could you clarify how non-qualified distributions are treated for NRAs? For example, if I withdraw the full balance before age 59½, how would earnings and contributions be taxed or withheld?

2. Regarding my Traditional 401(k) after leaving my company:

   • I understand I need to roll it over to an IRA.

   • Would it make sense to convert to a Roth IRA while I’m still an RA (paying income tax now) versus leaving it as a Traditional IRA?

   • I understand that as an RA, the tax on conversion would be at my ordinary income rate, which may be lower than the 30% withholding that applies if I withdraw as an NRA later. Could you provide guidance on which approach is generally more tax-efficient, especially if I expect to become an NRA in the future?

Thanks so much for your insights!

[Opus 17]

I'm hoping @pk  or @dmertz  can help follow up here, in case I make a mistake.

For a Roth 401k, that is taxable according to US law, because you were working in the US when you made the contributions.  That means that non-qualified withdrawals would be taxed according to US law, even if you are living overseas.  Withdrawal of contributions before age 59-1/2 is not taxed, but withdrawal of the earnings is income tax plus 10%. 

For a pre-tax 401k, you can probably leave the money in the 401k, you don't have to roll it over.  Most of the time, the company won't just kick you out.  However, you certainly have the option of rolling it over to an IRA.  Doing a Roth conversion now could save you taxes later, but this depends on your state of residence, and your home country's tax rules.

For the IRS (federal government), a Roth conversion will likely be taxed at 12%, 22% or 24%, depending on your other income, as long as you are still an RA.  If you withdraw the money later as an NRA, it is taxed at a fixed rate of 30%.  So just thinking about the federal government, you would pay less tax to the IRS by converting the money while you were an RA.  However, we also have to think about state income tax.  As an RA, you will pay state income tax on the conversion for the state you are living in, if you withdraw the money after leaving the US, the state doesn't tax it.   So if you are in California, for example, and paying 10%, you may pay less overall tax by withdrawing after you leave the country and paying the flat 30%.

And you also have to consider your home country.  If your home country taxes Roth IRA withdrawals, then you pay taxes twice, once to the US when converting and once to your home country when withdrawing, and because you don't owe US tax on the withdrawal, you can't file for an offsetting US tax credit.  If you withdraw regular IRA funds, you also pay taxes twice, to the US and your home country, but the US will usually give you a tax credit to (at least partially) offset the foreign taxes you pay on the same money.  

Also remember that conversions start a new 5 year clock plus the age 59-1/2 rule.  Even if you convert your pre-tax 401k to a Roth IRA and pay the taxes today, you will pay income tax on any new earnings you withdraw before age 59-1/2, plus a 10% penalty on the entire withdrawal if withdrawn in less than 5 years.

So I think you need to find out if China will tax your Roth IRA withdrawals, and you need to think about your state income taxes for your current US state of residence.  If China will tax the Roth IRA withdrawal, I think a conversion will probably hurt you in the long run, even though it may save on US taxes.  

Lastly, let's think about how the foreign tax credit works.  You won't ever pay less than the US tax.  For example, suppose China taxes IRA withdrawals at 20% and the US charges 30% to a NRA.  The US would give you a 20% offset so you pay 10% to the US and 20% to China, so the net result is the same 30%.  And the 10% penalty for early withdrawal is a penalty, not a tax, so it is not offset by foreign taxes.  For this reason, if you are planning on withdrawing the money before age 59-1/2, I suspect that it makes the most sense to do that before you leave the US and pay the taxes once and get it over with.  If you will leave the money until after age 59-1/2, then you have to next find out if China will tax Roth IRA withdrawals. 

[dmertz]

Tax withholding is 30% on the potentially taxable portion of a 401(k) or IRA distribution paid to an nonresident alien.  Tax liability for a nonresident alien is determined on Form 1040-NR.

[Opus 17]

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@dmertz wrote:

Tax withholding is 30% on the potentially taxable portion of a 401(k) or IRA distribution paid to an nonresident alien.  Tax liability for a nonresident alien is determined on Form 1040-NR.

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I believe that IRA and 401k withdrawals fall under the category of income "not effectively connected" with a trade or business because it is Fixed, determinable, annual, or periodical (FDAP) income.

https://www.irs.gov/individuals/international-taxpayers/fixed-determinable-annual-or-periodical-fdap...

FDAP income is taxed at a flat rate of 30% (not just withheld) unless there is a tax treaty with the other country that specifies differently.  See Form 1040-NR Schedule NEC. 

[pk]

@joywyx0 , generally agreeing with my colleagues @Opus 17  and @dmertz  on their excellent responses to your specific question, I would just like to add:

(a) while there is  article 17 of US-China tax treaty that refers to taxability of pension income allowing  the distributor country to tax the  income, there is no clearly articulated  as to whether the resident country can also tax the same income or not.  Obviously if this does happen then " elimination of double taxation" clause will come into focus.

(b) please note that if you have lived in USA as a resident for a longtime ( 7-10 years ), when you leave the country, you will need to get "sailing permit" --- this generally entails US collecting or get assurance of being able to collect  taxes due  ( and/or may be due at a later date  including the use of Mark to Market ).

Hence my general comment would be , if you do plan to leave the USA in the near future ( one to two years ) , consider planning the tax side, simplify / dispose  of US holding etc. using the services of a Tax Professional  familiar with International Taxation, especially persistence post departure.  There are too many "ands" ,"ifs" and "buts", "not-withstanding" etc. in this future scenario.  A very careful walk is suggested so as to minimize tax surprises.  IMHO

Xie-Xie

pk