A 401K in Australia can cost you a lot of tax – but there are ways around it.
US Retirement Plans in Australia
Let’s assume you have a 401k retirement plan. A 401k is a type of Individual Retirement Account (IRA) in the US.
Now you are returning from the US back to Australia. How is your 401k retirement plan taxed in Australia? That is what Bradley Murphy and Darren Catherall of Murphy Tax in Sydney will discuss with you in this episode. The answer might really scare you.
Bradley and Darren will also touch on the taxation of Australian super in the US which – you might remember – we covered in US 13 with Marsha Dungog of Withers Worldwide. As you might recall, the US including the IRS is seriously confused by our superannuation system.
Here is what we learned but please listen in as Brad and Darren explain all this much better than we ever could.
To listen while you drive, walk or work, just access the episode through a free podcast app on your mobile phone.
US Retirement Plans in Australia
There is a big mismatch between Australia and the US. Australia doesn’t recognise your 401k as a retirement plan. Just as the US doesn’t recognise your Australian super as a retirement plan either.
The result is that each country aggressively taxes the other country’s scheme. Without any of the tax concessions intended.
Australia treats your IRA as a foreign trust under s99B ITAA36. As a result, Australia taxes the gross distribution of anything that is not a return of the ‘corpus’. The corpus of your IRA is your and your employer’s contribution to your 401k retirement plan.
s99B is a far-reaching section because it deems everything as income first. And then works out what is included in your taxable income.
The taxing point is the same in both countries. No tax until payout.
No US or Australian tax on unrealised or realised gains or ordinary income like interest and dividends within your 401k fund. But the moment you receive a payout – that is the taxing point both in the US and in Australia.
401k v Super
And in this, a 401k is different to an Australian super fund. In an Australian super fund you pay 15% income tax on any income apart from funds within an account based pension, but then there is no tax upon payout unless you withdraw early.
In the US your 401k pays no tax unless you withdraw early, but then you might pay some tax upon payout. But just like the 15% in Australia, US tax rates on payouts are concessional, ie. less than what you would usually pay on income.
In the US you pay very little or no tax on a retirement plan payout. Which tax rate applies depends on whether it is a 401k, Roth, or a different IRA.
In Australia on the other hand, you pay marginal tax rates on your US retirement plan payout – no matter which type of IRA the payout comes out of. And so this can cost you a lot of tax.
In Australia, the entire gross payout goes into your taxable income. No 50% CGT discount – no deductions – no loss carryforward.
You lose your 50% CGT discount thanks – or no thanks – to s99B. That section reclassifies capital gains as income. So when you receive your 401k payout – no 50% CGT discount.
And s99B allows no deductions. It is the gross distribution you pay tax on. There is not even a deduction for a tax loss carried forward. So s99B is dangerous.
So let’s say you and your US employer together contributed $100k into your 401k while you worked in the US. The balance of your 401k grew to $1.1m. And now back in Australia you apply for early withdrawal of the full $1.1m.
In the US you might pay a 10% penalty if you withdraw early – before you turn 59.5 years. In addition, there might be some income taxes if you are still a US resident. If you are no longer a US resident, then the payout should not be taxable in the US.
Australian Income Tax
If you are an Australian tax resident at the time of the payout, Australia holds the taxing rights. Anything over the $100k original contribution goes into your taxable income.
401k v Direct Investment
401k in Australia can mean a significant amount of tax. The tax you wouldn’t have incurred if you had held the investments directly.
Let’s say your 401k only included Google Shares – theoretically speaking since your 401k doesn’t list specific assets. You paid $100k in and now you hold $1.1m worth of shares. The fund sells those shares and now your 401k holds $1.1m in cash.
When you now – back in Australia – withdraw the $1.1m, you have a taxable ordinary income of $1m.
If you had held the Google shares in your individual name, they would have reset their cost base to the market value at the time of your return to Australia. Let’s assume that was $1m. So when you now sell them for $1.1m a year or two later, you have a capital gain of $100k, less the 50% CGT discount, so $50k hits your tax return as taxable income.
Do you see the difference – $1m v $50k? That is why a 401k in Australia is so dangerous.
When you withdraw your 401k and request a transfer to Australia, your fund will apply withholding tax. The only way around that is supplying them with a W8-BEN form. That will hopefully stop them from withholding.
However, some funds withhold nevertheless – easier for them to just withhold than to carry the responsibility of maybe missing a withholding. If that happens and you receive your 401k funds reduced by withholding tax, you have two options. You either file a US return and claim back the tax withheld. Or you claim a FITO in Australia.
If you are an Australian tax resident and you have a 401k, you have a number of options. With all these make sure you don’t get hit with a 10% early withdrawal penalty in the US.
1 – Don’t touch your 401k until you are back in the US and no longer an Australian resident. Your 401k is only a problem in Australia if you withdraw from it while an Australian resident here.
2 – Change from an employee to a contractor in the US and have those theoretical employer contributions directly paid out to you. You then invest those directly in your own name.
3 – Withdraw from your 401k, contribute it into your Australian super as a concessional contribution and claim a tax deduction. Be mindful of the caps and use the bring-forward rules to your advantage.
4 – Spread your 401k withdrawals over several years to keep your income within a tax bracket you can manage. Let’s say you have no other income, then you can withdraw $20k each year completely tax-free.
Please Listen to the Interview
So this is what we took away from this talk with Brad Murphy and Darren Catherall. But please listen to the interview since Brad and Darren explain all this much better than we ever could.
Disclaimer: Tax Talks does not provide financial or tax advice. All information on Tax Talks is of a general nature only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.
Last Updated on 06 June 2022