First, a quick glance at how a 401k plan functions: A 401k plan is aimed to be a retirement plan wherein you contribute money every year into a plan selected by your employer. Your employer may choose to match your contribution up to a certain limit - that is, he may put in money equal to your contribution into your plan. Your contribution is made out of pre-tax dollars, that is, the amount of contribution is deducted from your taxable income in the year you make the contribution. The funds are locked in till you hit the age of 59 and a half. Withdrawals that you make after that will be taxed according to your tax bracket. If you want to make a premature withdrawal before you turn 59 and half, in addition to paying taxes, you will have to pay a penalty that could go up to 10% of the withdrawal.
The lock-in is what hits most NRIs. So what is the best thing to do?
Ethan Schneid, Partner at the New Jersey based financial advisory firm Kubhera Enterprises advices, "What you choose to do with your 401k plan would depend on your goals. For instance, if you need the money that is lying in your 401k account, you have no choice but to withdraw it and bear the taxes and penalties. But, if you don't need the money, this might be a good way to diversify your portfolio. Since investments of a 401k plan would be primarily in the US stocks and bonds market and that too dollar denominated, you get the opportunity to hedge against country risk and currency risk."
So what are the options if you decide to keep your investments in the US?
Option 1: Leave the plan alone
The first option is to just leave the 401k plan as it is. When you reach the exit age of 59 and a half, you can choose to withdraw the money. We will look at taxation on withdrawal a little later in this article.
Should you choose this option? "Well, there are two issues here," says Venkat Krishnaswamy, also a Partner at Kubhera Enterprises. "The 401k plan is restrictive in the way it is structured. The plan itself is selected by your employer and it is only within that selection that you can allocate your funds among various classes depending on your risk profile. Secondly, if at any point in time, your employer decides to terminate the 401k plan, that is, he decides that he will no longer offer the plan to his employees, you would then anyway have to mandatorily either withdraw or rollover to an IRA (Individual Retirement Account)."
Which brings up to the second option.
Option 2: Rollover to a traditional IRA
"The traditional IRA works in exactly the same fashion as the 401k, except that it is an individual account as against an employer sponsored account," Schneid explains adding, "In an IRA, the investor has more flexibility in choosing the fund options and managing his fund. Moreover, there are no tax consequences on moving your money (called rollover) from a 401k to a traditional IRA."
While all companies do not allow you to open an IRA if you have an international address, there are several of them who do. So do run a check.
Option 3: Rollover to a Roth IRA
A Roth IRA is also a retirement plan but the contributions made in a Roth IRA are out of post tax dollars, that is, no deduction is available from the taxable income at the time of making the contribution. Instead, the withdrawals from the Roth IRA are tax free to the extent of contributions made. Only the earnings, such as dividends and interest are taxed.
"If you are in a lower tax bracket at the time you move to India, then you may want to consider rolling over to a Roth IRA. At the time of rolling over, you would need to pay tax on the amount you roll over. Subsequently, your withdrawal becomes tax free (only earnings get taxed on withdrawal.) Another point to remember is that in a traditional IRA, when you hit the age of 70 and a half, you would need to make mandatory withdrawals called RMD (Required Minimum Distributions). No such requirement exists in a Roth IRA. So if you want to save up the Roth IRA for your children's higher education and you expect to be past age 70, this might be a good option. Of course you need to take into account your current tax slab," Schneid explains.
It might be a good idea to consult an independent advisor to make your choice, especially if the stakes are high. He will look at your risk profile, your financial goals, your tax profile and your cash flow position and then help you make an informed choice. Even after you have made the rollovers, it is important to continue to monitor your IRA account and actively manage it to suit your risk profile. Your advisor would help you do it.
Tax on withdrawal
A 401k plan and a traditional IRA will attract tax in the US on the entire withdrawal proceeds. In the case of a Roth IRA, the earnings portion will attract tax. So what happens if you are in India at the age of 59 and half? Let's take a look.
Situation 1: You make a lump sum withdrawal
According to the US IRS Tax Code, any income that comes from a source in the US is subject to taxes in the US, irrespective of whether the receiver of that income is a resident of the US or not. Now according to the Indian Income Tax Act, if you are a resident of India, then you will be taxed in India on your global income. By account of these two rules, it becomes clear that the withdrawal will fall under the purview of taxation in the US as well as in India.
In such cases, you would need to refer to the India US Double Taxation Avoidance Agreement. There is no specific section in the DTAA that deals with retirement funds so we refer to Article 23 which covers 'Other Income.' According to Article 23, if a person resident in India earns income that is arising in the US, that income would be first taxed in the US. So the payer of the withdrawal proceeds will withhold tax on the amount (at the rate of 30% for non resident aliens of the US). The resident Indian will then have to file his tax returns in India and declare his 401k withdrawal proceeds. He can claim a credit on the taxes paid in the US.
Dev Kini, a New York based CPA explains, "You would need to file your tax returns in the US even if tax has been withheld at source. If you have a refund due, you may claim it in the tax return. Subsequently, you will have to file your tax returns in India and you will be able to claim a credit on the tax withheld in the US in your Indian income tax return."
Situation 2: You make withdrawal as monthly pension
With an IRA, instead of making a lump sum withdrawal, you can choose to draw a monthly pension of a certain amount. Article 20 of the DTAA provides that any private pensions and annuities (does not include social security benefits or public pensions) received will be taxed only in the country in which the taxpayer is a resident. So if you are in India at the time of receiving the pension, you would be taxed only in India. You would then have to submit necessary documents to the payer in the US so that he would not withhold any taxes there.
Having said that, you would need to speak to your financial advisor and tax consultant to check if this option might suit your profile. For instance, Kini gives an example, "As a US citizen you would need to file your tax returns in the US, irrespective of where you live and what your income source is. So let us say you are a US citizen and having lived in the US for a long time you decide to move back to India, say at the age of 60. If you have no other income in India, it might be a good idea to consider withdrawing a pension and set the pension amount in such a way that it falls below the minimum taxable amount in the US. That way, you will have no tax obligations in the US. As a resident of India, you would need to report your global income in India. You would need to report this income in your India returns only."
Finally, what you choose to do with your 401k plan is a function of several things: your cash flow, your tax bracket, your risk appetite and above all, your financial goals. Take into account all these factors before making a decision.