You are correct: Generally, the IRS considers distributions from a US-based 401(k) or IRA to be US-source income. As a result, the foreign country is the one to issue you a tax credit depending on their tax laws.
One saving clause is if the US has a tax treaty with your country of residence, it almost certainly contains a "Relief from Double Taxation" article.
- How it works: Many treaties allow you to treat US-source income as foreign-source income for the specific purpose of claiming the Foreign Tax Credit.
- The Form: On Form 1116, you select the category "Certain income re-sourced by treaty."
- The Result: By "re-sourcing" the income, the IRS allows you to take the credit for the taxes you paid to your host country against the US tax you owe on that same distribution.
Your host country’s claim that they have the right to tax you is usually correct based on residency. Most tax treaties follow these general principles:
- Pensions: Are often taxable only (or primarily) in the country where the recipient resides.
- The "Saving Clause": The US always reserves the right to tax its citizens as if the treaty didn't exist. This is why you still owe the US.
- However, if the treaty says the income is taxable in your country of residence, and the US also taxes you because of your citizenship, the US (not the host country) is usually the one required to provide the relief via the "re-sourcing" method mentioned above.
In retrospect, you may be able to file a Foreign Tax Credit on Form 1116 but depends on the tax treaty the US has with the country you reside in.
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