Global Mobility: Taxation of 401(k) Payments in Non-U.S. Jurisdictions — Germany
By Ralf Ruedenburg, Tax Partner & Head of German Desk
The U.S.-German tax treaty allocates the right to tax 401(k) payments that German tax residents receive solely to Germany. Under German tax rules and regulations, 401(k) payments are treated as other income.
A recent German tax court decision determined that 50% of the difference between 401(k) contributions and a lump-sum payment received by a German tax resident has to be included as taxable income and is subject to individual income tax in Germany.
Generally, non-U.S. individuals need to consider the U.S. tax implications when participating in 401(k) plans while working in the U.S. and for payments that will be received after retirement when they may not be U.S. tax residents anymore.
If the 401(k) distributions are subject to tax in a non-U.S. jurisdiction, taxpayers may have to produce supporting documentation to show contribution amounts so that taxable profit can be calculated.
Social Security, governed by the U.S. Social Security Administration, and retirement savings plans, such as 401(k) plans, are two of the key systems from which American workers can receive payments after retirement. 401(k) plans can be offered voluntarily by employers and are generally funded by pre-tax contributions from employees. Employers may match all or part of the contributions. In either case, amounts are contributed to the plans on a pre-tax basis. Contributions are generally invested in equity or bond funds based on the risk strategy determined by the employee. The return on investment over the years is typically higher than that which would have been earned in the Social Security system.
401(k) plans determine eligibility to participate based on the plan documents. Multinational employers may offer participation in the plan to non-U.S. expatriates who are assigned to work in the U.S. for a certain period of time.
Contributions to 401(k) plans are pre-tax, i.e., the portions of the salary or wages that are paid into the plan during employment are not subject to income tax. Withdrawals from the plan are subject to ordinary income tax rates. Penalty-free distributions are possible after the age of 59-1/2. Early distributions are subject to an additional 10% tax unless an exception applies.
As expatriates generally return to their home country after their U.S. assignment, they are not U.S. tax residents when they are eligible for 401(k) withdrawals unless they are still U.S. tax residents as U.S. citizens or green card holders.
The question then arises, if and where 401(k) payments in the form of one-time payments or periodic recurring payments are subject to tax. In general, the 401(k) payments would be sourced to the U.S. where the services were rendered. If, however, the U.S. has a tax treaty with the foreign jurisdiction, treaty documents must be analyzed to determine which country has the right to tax the payments.
U.S.-German Tax Treaty – Treatment of 401(k) Payments
A recent tax court decision in Germany determined that 50% of the difference between 401(k) contributions and a one-time payment received is subject to income tax in Germany as other income. The decision is not final and has not been decided yet by tax courts in Germany. The parties have appealed, and the case is now with the tax supreme court.
A German citizen was assigned to work in the U.S. for a period of nine years. During this time, he participated in a 401(k) plan and made pre-tax contributions. He was eligible to withdraw funds from the plan after he had returned to Germany. At that time, he was solely a tax resident of Germany. He reported a one-time lump sum distribution and claimed tax-free treatment according to German tax rules. The German tax authorities denied the claim and included 100% of the difference between contributions made by the taxpayer to the 401(k) plan and the amount received as taxable income. The taxpayer appealed and the case was decided by a tax court in Germany.
The Decision (on Appeal)
The tax court ruled that 401(k) payments fall under Article 18 of the U.S.-German tax treaty. Article 18 assigns the right to tax such payments solely to Germany if the recipient is a German tax resident only.
Under German tax rules and regulations, 401(k) payments are subject to income tax as other income because 401(k) plans are similar to certain pension plans in Germany. There is no limitation to domestic retirement plans when it comes to the determination whether income is taxable in Germany or not. In this specific scenario, 50% of the difference between contributions made by the taxpayer and the amount received were subject to income tax in Germany.
As this matter has not been decided previously, the tax court allowed the parties to appeal the decision. The case is now with the tax supreme court in Germany.
The following table shows the contributions made, lump-sum distribution received as well as the initial tax treatment and correction after the tax court decision. The amounts are rounded.
Initially included as taxable income in the year of distribution
Amount to be included as taxable income in the year of distribution according to the tax court decision
PKF O’Connor Davies will follow the developments in this case and will report in the future about the outcome of the tax supreme court decision in Germany.
PKF O’Connor Davies Recommendation
Tax implications for expatriates when participating in retirement plans in the U.S. need to be considered as part of the tax planning, and they should include an analysis of tax implications related to payments that may be made long after the working assignment has ended.
If you need any assistance, please reach out to your PKF O’Connor Davies client service team or:
Ralf Ruedenburg, CPA
Head of German Desk
646.965.7778 I email@example.com