IRA contributions by foreign nationals: long-term investments with short-term returns.

Individual retirement accounts (IRAs) provide a unique opportunity for foreign nationals in the United States. Generally, IRAs are available to individuals who earn below a certain income amount or who are not covered (or eligible to be covered) by a U.S. qualified retirement plan. Since many company pension/retirement plans exclude individuals on temporary assignments from participating these individuals are then eligible to make deductible IRA contributions. These contributions provide a direct offset to taxable earned income and would continue to earn interest and/or dividends that would not be currently taxed in the United States. When such an individual receives a distribution from an IRA, it is then taxed at normal U.S. graduated rates. If the individual were to take the money before reaching age 59 1/2, in addition to regular tax, he would pay a 10% penalty.

The reason an IRA contribution is an especially good opportunity for a foreign national is that he would receive a tax benefit in the year the contribution was made at his highest marginal tax rate; however, in the year the contribution is withdrawn from the account, assuming the foreign national is no longer a permanent U.S. resident, the first $2,350 (personal exemption available to non-resident aliens) would be tax free, and any remaining distribution would be taxed according to the graduated tax brackets, starting with 15%. Even if the foreign national were to receive the distribution before reaching age 59 1/2, the 10% penalty plus a 15% regular tax would still be lower than the benefit the individual received in the year of contribution, and the tax payment would have been deferred.

Another reason that IRA contributions provide a unique opportunity, particularly to foreign nationals from the United Kingdom, is the possibility that all tax, including the 10% penalty on early withdrawal, may not apply to the distribution. This position is based on IRS Letter Rulings 8422069 and 92534049. This second ruling allowed a U.K. citizen/resident to apply paragraph 1 of Article 22 (Other Income) of the U.S.-U.K. Income Tax Convention to the amount distributed from an IRA.

The facts in the letter ruling mirror the situation of many foreign national transferred from the United Kingdom for a temporary U.S. work assignment. The foreign national made contributions to the employer pension plan, which were subsequently rolled into an IRA, during the years he was a lawful permanent U.S. resident working for a U.S. corporation. When the foreign national returned to the United Kingdom, he intended to distribute the funds from the IRA to himself for investment in the United Kingdom. A ruling was requested as to the U.S. tax treatment of these funds.

Article 18(1) (Pensions) of the U.S.-U.K. Treaty provides in general that pensions are taxed based on the recipient's residence. While generally an IRA is not a pension, in certain circumstances the Technical Explanation of the Treaty could be interpreted to classify an IRA in the Pension article of the treaty. However, a payment from an IRA before the individual attains age 59 1/2 is not a pension payment; therefore, Article 18 of the treaty does not apply. Since the payment from the IRA is not specifically covered in any treaty, it should governed by Article 22 (Other Income).

Article 22, paragraph 1, provides that items of income of a resident of a Contracting State, wherever arising, will be taxed only in that State. Because the individual would be resident in the United Kingdom at the time of distribution, the United Kingdom would be the only country able to impose a tax; however, because the distribution is not income for U.K. purposes (but rather a return of previously deposited capital), it should not be taxable in the United Kingdom.

Consequently, the individual is able to receive a deduction for the contribution but pay no tax on the distribution. Thus, an investment vehicle with significant tax benefit, set up to be a long-term investment, can be a short-term savings with notable advantages.