How Are 401(k) Withdrawals Taxed for Non-Residents?

If you live and work in the U.S. on a visa, you may be considered a non-resident alien. The Internal Revenue Service (IRS) defines a non-resident alien as a non-U.S. citizen who is legally present in the U.S. without a green card or who doesn’t pass the substantial presence test.

As a non-resident alien, you may invest in a 401(k) offered by your employer. But, this can be complicated if you deplete your account when you return to your home country because you will be taxed and penalized. Keep reading to learn how to solve this non-resident 401(k) conundrum.

Cashing Your Funds Out

The rules for early withdrawals are the same for U.S. residents and non-resident aliens. According to the Internal Revenue Service, you can’t withdraw money from a traditional or Roth 401(k) plan until you reach age 59½ or become permanently unable to work due to disability.

Beware the Early Withdrawal Penalty

If you are younger than 59½, not disabled, and take cash from your 401(k), you’ll be subject to a 10% early withdrawal penalty. So, if your 401(k) is worth $15,000 and you decide to liquidate the account, you’ll be required to pay an additional $1,500 in taxes. That means your withdrawal is essentially slashed to $13,500.

Your entire 401(k) withdrawal is taxed as income by the U.S. even if you return home. Because contributions to traditional 401(k) accounts are made with pretax dollars, this means any withdrawals are included in your gross income for the year you take the distribution.

Let’s say your income tax rate is 22% in the year you liquidate your 401(k). This drives the total tax impact up to 32% for that withdrawal (the 10% early withdrawal penalty + the 22% income tax rate).

So when you withdraw $15,000 from your 401(k), you’ll have to pay a total of $4,800 in taxes, which whittles down the total of your take-home amount to $10,200. This is precisely why many financial advisors tell U.S. residents that cashing out their 401(k) before they hit 59½ isn’t the smartest option.

The Delaying Game

A tax expert may offer different advice if you’re a non-resident planning to return home. If you move back and wait until the next tax year to cash out your 401(k), you will most likely fall into a lower tax bracket since you won’t be working and earning income in the U.S.

This could greatly reduce the amount of income tax owed on the distribution. Remember: No matter where you live when you cash out your account, you’ll still have to pay the 10% early withdrawal penalty if you’re younger than 59½. 

Rolling Your Funds Over

Another way to lower your tax payment on a 401(k) withdrawal is to transfer the funds to another tax-advantaged account, such as an individual retirement account (IRA). When you take a direct rollover from your 401(k) to an IRA, you avoid the 10% early withdrawal penalty. To pull this off, you’ll need to open the IRA first and fund it with the 401(k).

The Penalty-Free Withdrawal

You still incur the early withdrawal penalty but there’s “more flexibility in terms of exceptions for avoiding the penalty like unreimbursed medical expenses, first-time homebuyer, disability” if you take a distribution from your IRA before 59½, according to Mark Hebner, founder, and president of Index Fund Advisors and author of “Index Funds: The 12-Step Recovery Program for Active Investors.”

You can make a penalty-free early withdrawal from an IRA for qualified higher-education expenses, such as tuition, books, and supplies for enrollment at an eligible institution–plus a specified amount for room and board if you attend at least half-time. The IRS notes that some overseas educational institutions participate in Federal Student Aid programs so check with the school first to see if it is considered an eligible educational institution.

Keep in mind that IRA distributions sent to an address outside of the U.S. are subject to mandatory federal withholding of 10%. However, some financial institutions allow you to waive this withholding by filing special documents. If you take this route, your distribution will be subject to the treaty rate of your current country. The treaty rate ranges from zero to 30%.

The Home Country Option

Once you roll your 401(k) into an IRA, you may also choose to transfer the IRA funds to a retirement account in your home country. For example, Canadian citizens can roll over their U.S. IRA plans to a registered retirement savings plan (RRSP). As a Canadian resident, not only do you end up with the 10% early withdrawal penalty if you aren’t 59½, but you’ll also have to pay taxes to both the U.S. and Canada.

The Bottom Line

Withdrawals from 401(k)s are taxed the same way for residents and non-residents. If you plan to return home, you can cash out the account, roll it over into an IRA, or leave the funds until you turn 59½ and can start taking penalty-free withdrawals.

“Although you are allowed to leave your funds in the 401(k) until turning age 59½ or later, the funds would be subject to your employer’s options and fees,” says Carlos Dias Jr., founder and managing partner of Dias Wealth. It is also important to note that some investment firms are reluctant to have an investment account held by an individual no longer living in the U.S.

Before you make this important decision regarding your 401(k) withdrawals, consider speaking with a financial professional or tax attorney.