Tax Status of 401k Rollover | Ed Slott and Company, LLC

Tax Status of 401k Rollover

This is an unusual situation and I haven't been able to find an answer. Perhaps someone else has dealt with this. I have a client who worked for the British Embassy in the United States until a few months ago. She is a dual U.S./British citizen. The income she earned there was not taxed by the U.S. Government. She contributed to a 401(k) plan (not recommended by me) while she was employed. She is interested in rolling her British Embassy 401(k), currently at ING, to an IRA. My question is how the 401(k) account is viewed for tax purposes - is it an after-tax account (like a Roth) or a before-tax account? (It's really a no-tax account, if there is such a thing.) My concern is that I don't want to turn a tax-free account into a taxable account in the process of rolling it over. I suspect it needs to be rolled into a traditional IRA but I'm just not sure. The client, by the way, has asked human resources about this, but they didn't seem to have the answer either. Thanks for any insight/comments.

You state that the compensation earned by your client, a US citizen working for the UK government in a British Embassy in the US, is excluded from US taxable income. I suggest that you review your client's W-2 and US tax return. I suspect that the W-2 shows (for example) $100,000 gross income and $15,000 elective deferral to the Embassy's 401k plan and that the tax return shows $85,000 foreign income exclusion and no US tax liability. (The foreign income exclusion applies if your client is a UK resident for purposes of US tax and if a British resident working at the British embassy in the US is considered working outside the US.) If this is the situation, her 401k can be rolled to a traditional IRA with no immediate income tax consequences. Elective deferrals to a 401(k) plan cannot exceed 100% of taxable US compensation. If the W-2 shows no US compensation, her contributions to the plan were in excess of her compensation and must be distributed. Revenue Procedure 92-93 is relevant. The distribution of an excess contribution is included in income in the year distributed. The distribution is taxable income even if no deduction had been allowed for the original contribution(s). Second, the distribution is not an eligible rollover distribution. Thus the distribution cannot be rolled or transferred to an IRA. This revenue procedure addresses excess additions "due to the allocation of forfeitures, a reasonable error in estimating a participant's compensation, or a reasonable error in determining the amount of elective deferrals." I suspect that a plan which routinely allows contributions in excess of taxable US compensation is not making a reasonable error. The plan is likely to be disqualified if the IRS discovers what is going on and that the consequences will be disastrous for all participants. My suggestion is to check the W-2 and tax return and, if necessary, discuss the situation with an enrolled actuary who is familiar with the IRS voluntary pension correction program.

Thanks for your response, Peter. While I have seen the tax returns (no income reported), I do not have a W-2 to review, which I now realize may be very helpful.

The tax treaty with the UK (Article 19) says that the US generally does not tax the wages of UK residents who are working in the US as employees of the UK government. However, the savings clause (Article 1, paragraph 4) says that this provision does not apply to US citizens. So I don't understand how wages (Form 1040, line 7) can be zero on the tax return of a US citizen/UK resident working for the UK government. Please post the explanation once you have figured it out. It looks like your customer is in the soup and the entire pension plan along with her. I urge you to get competent advice since I find it hard to believe that the employer (the UK government) could screw up so completely.

Peter - She is a U.S. resident with dual U.S/British citizenship. She was working for the British Embassy in the U.S.

I don't understand why income earned by a US citizen living and working in the US would not be reportable somewhere on her US tax return. I look forward to learning the explanation once you have figured it out.

Dual U.S.- U.K. citizens employed at consular locations are exempt from U.S. tax under Article 13 of the U.S. ‒ U.K. Consular Convention.

Article 13 of the July 6, 1951 US/UK "Consular Convention" - as distinct from the 2001 US/UK "Tax Treaty" - says that the salaries of UK citizens and US/UK dual citizens who are employed by UK consular offices in the US are exempt from US, state and local taxes. The convention can be found at travel.state.gov/law/legal/treaty/treaty_1507.html. This convention is apparently the reason that your customer did not report her wages at the UK Embassy on her US tax return. Is tax exempt consular income "compensation" for purposes of contributing to a 401k plan? Reg. 1.415(c)-2(g)(5)(i) says that "... compensation for services do not fail to be treated as compensation under paragraphs (b)(1) and (2) of this section (and are not excluded from the definition of compensation pursuant to paragraph (c)(4) of this section) merely because those amounts are paid by an employer with respect to which all compensation paid to the participant by such employer is excluded from gross income." Kudos to gsmith!
 

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