401(k)-Plans and German taxation
von Peter Scheller
US pension plans are an important cornerstone of retirement planning both for US citizens and US residents. As long as citizens and residents remain in the USA the tax consequences are straight forward. However, if a US citizen or a citizen of another state relocates to Germany and withdraws money from such a plan, the tax situation changes and becomes more complex. This is particularly so because many questions regarding the German taxation of withdrawals form 401(k)-plans or IRAs are still unresolved. However, a recent ruling of the German Federal Fiscal Court clarified one outstanding point.
The court case related to a German citizen who worked in previous years in the USA for a US employer. He was in a company pension plan (401(k). The citizen returned to Germany and withdrew money from the 401(k)-plan while being tax resident in Germany. There was no dispute between the German tax authorities and the complainant that the withdrawal was taxable income in Germany. In cases like this, Article 18 (1) of the Double Taxation Convention between Germany and the USA (DTC USA) gives Germany the right to tax payments from US pension plans. The question was which provision of the German income tax law is applicable in such cases.
- The German tax authorities took the view that the full amount of the withdrawal has to be taxed in Germany as regular income. The argument they took was that contributions to qualified US pension plans are subject to special tax benefits in the USA since they are paid out of non-taxed income (pre-tax). As withdrawals from qualified German pension plans would be subject to a full taxation in Germany, the view was that the same should apply to US pension plans which enjoyed the same tax benefits in the pay-in phase.
- The argument of the claimant was that the relevant German provision is only applicable to qualified German pension plans because only German tax benefits are specified in the relevant tax code. Foreign tax benefits are not specified in the list and should therefore be disregarded. The view of the claimant was that another provision of the German income tax code is applicable, namely the provision allowing the taxation of the difference between a withdrawal and the contributions attributed to that withdrawal.
Example: A person who is tax resident in Germany withdraws 100,000 $ from the 401(k)-plan. The funds of the plan before withdrawal were 200,000 $. In the pay-in phase the employee and the employer paid contributions to the total amount of 80,000 $. If the opinion of the tax authorities is correct, 100,000 $ should to be taxed in the year of withdrawal. If the other opinion is correct only 60,000 $ (100,000 $ minus ½ of 80,000 $) would be taxed in Germany.
The Fiscal Court of Cologne ruled in 2018 that only the difference between the withdrawal and the attributable contributions is taxable income. The Federal Fiscal Court (which is Germany’s highest fiscal court) confirmed the judgement. It ruled that the provision in the German income tax code does not include foreign tax benefits and it is not the function of a court to alter the wording or meaning of a law or legal provision of it. Therefore only the difference between the withdrawals from a plan and the appropriate attributable contributions can be taxed in Germany.
This ruling is also applicable to US citizens who relocate to Germany and withdraw money while being tax resident in Germany. The difference to the above mentioned court case is that US citizens have to declare such withdrawals in their US tax return as ordinary income. This is due to the fact that the so called saving clause (Article 1 (4) DTC USA) allows the US to tax its citizens regardless of where they are resident. A double taxation scenario is mitigated by the fact that the USA will credit the German income tax against the federal US income tax. If the German tax on the withdrawal is higher than the US tax the combined tax burden will be higher than the US income tax alone. Therefore this ruling also applies for US expatriates who relocate to Germany and withdraw money from a plan of major importance.
Various questions surrounding withdrawals from foreign pension plans are still to be resolved:
(1) Which plans are covered by the above ruling?
The ruling covers withdrawals from a 401(k)-plan. The same should also apply for other company plans and plans of the US government or other institutions. Protocol 16 (a) aa to the DTC USA specifies the following plans which are accepted by the German tax authorities:
- qualified plans under section 401(a) of the Internal Revenue Code
- individual retirement plans (including individual retirement plans that are part of a simplified employee pension plan that satisfies section 408(k)
- individual retirement accounts, individual retirement annuities, and section 408(p) accounts
- section 403(a) qualified annuity plans
- section 403(b) plans
- section 457(b) governmental plans
The same should apply for private plans such as Individual Retirement Accounts (IRA). It is unclear whether the ruling also applies to non-qualified retirement plans. My opinion is that a plan should be be classified as a pension plan if it covers a significant biometric risk such as longevity, death, incapacity to work, disability or care for dependents and are in general paid after reaching retirement age. Pension plans from other countries have to be analysed carefully. They have to be comparable in legal and economical structure to German pension plans or pension insurances in order to be covered by the ruling.
Withdrawals from Roth-401(k) plans or Roth IRA should also be covered by the German provision (withdrawal minus attributable contributions) even without the ruling since contributions have been made out of taxed income (ie after tax). These plans are not favorable for persons who are tax resident in Germany because in the USA the withdrawals are tax free but not so in Germany.
The ruling is applicable on these kinds of pension plans as well.
(2) What happens to roll overs?
Roll overs are transfers of funds from one plan into another plan. Often funds of a 401(k)-plan are transferred into a (private) traditional IRA. There are various kinds of roll overs such as direct roll overs when funds will be directly transferred from one plan into another. There are indirect rollovers when funds are paid out to the beneficiary and he or she pays the funds into another plan within a 60-day period (also called 60 days roll overs). In general roll overs are not taxed in the USA. An exception is the rollover from a 401(k)-plan into a Roth IRA which is subject to US income taxation.
In Germany the transfer of funds from a qualified pension plan into a private pension plan is in general a taxable event. The withdrawal from the plan will in most cases be subject to German income tax. However, Article 18A (1) DTC USA states that Germany does not have the right to tax roll overs from one US pension plan into another one.
This is a special provision of the DTC USA. Double Taxation Treaties between Germany and other countries do not have a similar provision. Nonetheless, other countries such as the United Kingdom also recognise tax-free roll overs. Expatriates from these countries should be careful if they intend to roll over funds from one plan into another plan while being tax resident in Germany. This could end up in very unpleasant tax consequences.
(3) Is half of the difference applicable?
Germany’s above mentioned rule has a special extension. If the beneficiary is 60 years of age or more and the plan or insurance contract has existed for more than 12 years, only half of the difference between the withdrawal and the attributable contributions is taxed in Germany. In the above mentioned example only 30,000 $ would be taxed. If the contract was agreed after 31 December 2011 the beneficiary must be 62 years of age to benefit from this rule. The ruling of the Federal Fiscal Court did not clarify whether this specific rule is applicable to foreign pension plans. However, in my opinion there is no obvious reason why this rule should not be applicable to foreign pension plans.
Still unresolved is the question of whether a roll over would be ignored in determining the 12-year period or whether the 12-year period starts new with the date of the roll over? There are no statements of the German tax authorities nor any rulings of German fiscal courts in this respect. Therefore expatriates should be careful to roll over funds from one into another plan before or after relocating to Germany.
(4) Is the penalty tax deductible?
In general a person who withdraws money or funds from a qualified US pension plan before he or she reaches 59 ½ years of age would have to pay a penalty tax of 10% (in addition to the regular income tax on the withdrawal) in the USA. Still unresolved is whether this penalty tax is then tax deductible in Germany. There are pre-court proceedings pending where German tax authorities have to decide whether to allow the deduction or not. Whether these cases will lead to court cases remains to be seen.
(5) How to prove the total amount of contributions?
Often it is difficult or impossible to provide proof of paid contributions. This is especially the case with plans that have been running for a long period of time or with inherited IRAs. If there is no full documentation available it is sometimes advisable to ask financial institutes (trustees) or insurance companies for help but even then it is not always possible to get conclusive documentation. In this case the only way to proceed is with educated guesswork. Whether German tax authorities would accept such estimates remains to be seen.
Peter Scheller, Steuerberater, Master of International Advisers, Fachberater für Zölle und Verbrauchsteuern
Alexander Wangerowski, Steuerberater, https://aw-stb.de/
- Federal Fiscal Court
- income taxation
- Individual Retirement Account
- penalty tax
- pension plans
- roll overs
- Traditional IRA