Most of the returning NRIs from USA who have spent considerable time abroad have a good chunk of the total investment corpus invested in 401K plans and hence have a question on taxation of their 401K/IRA investments in India.
401K/ IRA taxation in India is a complicated area and considering the applicable penalties on foreign income & assets under the Black Money Law (Read: Retuning NRI/OCI’s Guide to India’s Black Money Act) makes it very important that there is no slippage on compliance aspects. In this post, I am discussing taxation aspects of 401K/IRA especially from the point of view of NRIs who’ve returned to India.
Also read:
Before we proceed, a few points
- Information in this post is “general” information. Please do not construe it as tax advice. Check with your CA with specific and detailed facts before you take any decision.
- As regards pointers on US tax law in this post, please note that my understanding on US tax law is limited. I advise you to seek professional advice from a licensed CPA before taking any investment or tax decision on your 401K investment.
- The post is mainly written from a 401K/IRA perspective – however, it is equally applicable to other Retirement Accounts in Canada, UK & Northern Ireland (countries specified by Income Tax Department for purposes of Rule 21AAA) as far as Indian tax law is concerned.
- Whether a person should contribute to 401K/IRA during stay in USA, should one liquidate 401K/IRA on return to India – these are all great questions but need to be looked at holistically from a personal financial planning perspective and not just tax perspective – I have discussed these issues in this post: Should I withdraw my 401K/IRA on return to India?
Understanding implications of 401K/IRA in India and USA
First thing is to understand what will be the implications if you retain or withdraw the 401K/IRA money because only when you know the implications, you will be able to take a proper decision.
USA Tax Implications of 401K/IRA in USA
- Retain till 59.5 years: No tax implication on income/ capital gain on re-allocation in USA – income grows tax deferred in USA.
- Withdrawal before 59.5: Withdrawal amount becomes subject to federal tax, state tax as well as 10% federal penalty tax
- Withdrawal after 59.5: Withdrawal amount is considered as income and liable to tax at applicable rates at that point in time
India Tax Implications of 401K/IRA in USA
If you wish to hold the 401K till 59.5
Prior to April 1, 2021, 401K taxation in India was very complicated as there were no clear guidelines. The issue was the time mismatch between taxation of gains in India & US. India taxes 401K accretion on accrual basis every year whereas US taxes it at the time of withdrawal. Thankfully from FY 2021-22 onwards, Government introduced a beneficial provision by way of Section 89A of Income Tax Act. This allows a resident to defer the tax of retirement schemes from notified countries to the financial year in which host country (in this case, US) taxes it (i.e. the year of withdrawal). Section 89A prescribes Rule 21AAA which lays down detailed guidelines on how to claim this exemption. The main points from the reading of the law reads as follows:
- Assessee has the OPTION to defer the tax to the year of withdrawal.
- Option has to be exercised in Form 10EE & furnished electronically on or before due date of filing tax return.
- Option once exercised will apply for all subsequent financial years & cannot be withdrawn.
- The option shall be exercised for all specified accounts taken together – so if assessee has multiple 401K/IRA accounts, all will be clubbed together.
- If the assessee leaves India & becomes non-resident in any financial year, all the incomes tax-deferred under this section will be taxed in the financial year in which she becomes non-resident.
So basically you do this one time filing of Form 10EE in India & you can hold the 401K money till age 59.5 & there is no tax implication to you in India as well as USA. However, bear in mind that after your residential status becomes resident & ordinarily resident, every year you need to declare income from 401K in Schedule FSI and the amount of 401K balance in Schedule FA in tax return. And no matter your income level in India, since you hold assets out of India, you need to mandatorily file returns in India. Also read – How NRI should disclose their foreign income/ assets in Indian tax return
Tax on withdrawal stage
Here the taxation in India will depend on your residential status in India at the time of withdrawal. So if you qualify as a Non-Resident or Resident & Not Ordinarily Resident (RNOR), there is no tax impact & disclosure requirements to you. This is why once you return back to India & get the 2-3 year RNOR window, you should take a clear call on your 401K & sell it if you wish. Seling 401K or not should not be decided only from a tax point of view but also from a holistic personal financial angle. Read this post for more info – Should I withdraw my 401K/IRA on return to India?
Coming back to taxation, if you become an ROR & withdraw your 401K, you will be taxed in USA as well as India on the money. In US, the entire withdrawal is treated as “ordinary income” and taxed as per slab rates. For US taxation, please consult a CPA.
Coming to India taxation, there is no tax on accretion of fund in 401K till you are an RNOR. Once you become an ROR, you can calculate the difference between the withdrawal amount & the fund value as on April 1 of the financial year you become ROR and offer it to tax under the head “Income from Other Sources”. That income will be taxable as per the normal slab rates applicable to you in India at that time.
If the corpus is big, you should also pay applicable advance tax to avoid interest u/s 234B of ITA. For the sake of brevity, I am not going into advance tax calculation aspects here.
Tax paid in the US on that money can be claimed as foreign tax credit in India tax return basis getting Tax Residency Certificate in Form 10F.
Since the tax calculation is complex & there are severe implications of under-reporting of foreign incomes under Black Money Law, it is advisable to hire a competent CA well versed with 401K taxation to handle your return filing.
Just to summarise above, the taxability of 401K/IRA under ITA on withdrawal will be as follows:
- NR/ RNOR: No tax implication in India
- ROR: Offer accretion from the financial year you became a ROR to the date of withdrawal of fund as “Income from Other Sources”
Application of India-USA DTAA to 401K withdrawals by Resident of India
Now let us explore DTAA applicability on the 401K withdrawal to see if we can find exemption to taxation in India or some lower rates of taxation in India. Note that the DTAA contains various Articles depending on the type of income. However, there is a lack of clarity and different opinions on which Article this income will fall.
In my view, income from 401K withdrawals will not fall in below articles –
- Dependent Personal Services – because there is no relationship of employee-employer that exists
- Dividend – Because there is a capital gain element also
- Capital Gains – because there is a income from dividend element also.
- Private Pensions – because 401K withdrawal is not per-se a private pension. Its more like a return on investment.
So, in my view, since the income does not relate to above specific income related articles, the Article that is applicable to this income is the residuary Article i.e. Article 23 on Other Income. Below I have captured the text of Article 23 of India-USA DTAA –
ARTICLE 23
OTHER INCOME
1. Subject to the provisions of paragraph 2, items of income of a resident of a Contracting State, wherever arising, which are not expressly dealt with in the foregoing Articles of this Convention shall be taxable only in that Contracting State.
2. The provisions of paragraph 1 shall not apply to income, other than income from immovable property as defined in paragraph 2 of Article 6 [Income from Immovable Property (Real Property)], if the beneficial owner of the income, being a resident of a Contracting State, carries on business in the other Contracting State through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed base situated therein, and the income is attributable to such permanent establishment or fixed base. In such case the provisions of Article 7 (Business Profits) or Article15 (Independent Personal Services), as the case may be, shall apply.
3. Notwithstanding the provisions of paragraphs 1 and 2, items of income of a resident of a Contracting State not dealt with in the foregoing articles of this Convention and arising in the other Contracting State may also be taxed in that other State.
(emphasis supplied)
If we analyse this article, the relevant clause is 23(3) – which clearly states that both states (USA & India) will have right to tax this income in their respective jurisdictions. So in my view there is very less scope for claiming exemption/lower rate as per DTAA.
So it is a better option to pay tax in India as well USA & In Indian tax return, claim foreign tax credit of the tax paid in USA.
Even in above case, a big practical issue will arise: Tax withheld in USA will be on the total withdrawal however under Indian Income Tax Act, you declare income & pay tax only on the accretion after you became ROR. So whether you should claim FTC on entire tax payment in USA or not?
India Black Money Law Implications of holding 401K/IRA in USA
In 2015, India enacted Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act (known as Black Money Act). This law is effective July 1, 2015 and requires a person who is a resident and ordinarily resident under the ITA to disclose foreign income and assets in his tax return in India. Also Read: Retuning NRI/OCI’s Guide to India’s Black Money Act
Generally, it is a settled legal principle that penalty and prosecution can be imposed when mens rea i.e. a culpable state of mind is established. The most draconian element in Black Money Act is that the court will assume a culpable state of mind and onus is on the assessee to prove that non disclosure was inadvertent and not with a malicious motive to avoid tax. Also, there is no provision for compounding of offence like it exists in FEMA and ITA.
A 401K/IRA forms part of the definition of foreign asset. Though an exemption is given from disclosure for foreign bank accounts upto INR 5 lacs, note that 401 does not qualify as a bank account hence disclosure is required of the amount standing to the credit of 401K around the date of filing the tax return.
Also, corresponding changes have been made in Section 139 of ITA making any person having ROR status in India and holding foreign assets/beneficial interest to mandatorily file a return of income in India irrespective of the income in that financial year. A separate schedule named Schedule FSI and FA are given in the tax return where these income/asset disclosures need to be made.
Also Read: How NRI should disclose their foreign income/ assets in Indian tax return
So, if you are an ROR, if you hold a 401K/IRA outside India, then irrespective of your taxable income for the year, you are required to file a tax return in India & disclose the foreign income & asset in Schedule FSI & FA every year. This point is especially relevant to homemakers who were working in USA and contributing to 401K/IRA, and after returning to India and becoming an ROR, are not working and thus do not have a taxable income in India.
In short, the disclosure requirement for 401K/IRA as per the Indian Black Money Law will be as follows:
- NR or RNOR: No disclosure required unless income is directly received in India
- ROR: Tax Return needs to be filed & disclosure is required
If you have failed to make a disclosure of 401K in your tax return after becoming ROR, severe penal implications can follow in terms of tax, penalty and prosecution under Black Money Act. In such cases, I will advise you to not to dilly-dally and seek proper professional opinion. Some pointers here are as follows:
- If you’ve not filed a tax return for a year or missed disclosing this income/asset in tax return, file a revised return if possible.
- If you have missed timeline of filing revised return, explore filing an updated return u/s 139(8A) of Income Tax Act. The timeline for this return is 24 months from end of the relevant assessment year.
- If even the window of filing updated return has expired, you can write to the Assessing Officer asking for an opportunity to update the return stating that the foreign income/assets non-disclosure was unintentional. Keep a copy of communication with AO in your tax file.
Other Important points on 401K/IRA:
- Ensure that the withdrawal from 401K/IRA is NOT directly credited to Indian bank account: keep one US bank account alive till you receive all the money – receive money in US account and then remit to Indian account. This is especially important for people in NR/RNOR period – in such a case, though income is not taxable in India, ITD can try to tax it in India as income “received” in India is taxable irrespective of a person’s residential status.
- If you have updated your address in the records of your 401K/ IRA provider to a non-US address, you should without fail file a W-8 BEN to possibly avoid withholding tax. If a withholding tax is deducted, you can explore filing a tax return for that year in USA to claim a refund. Talk to CPA for more clarity.
- If you have multiple 401K accounts (having worked with multiple employers), you can consolidate all such accounts into a single IRA account – this seems to be a good idea to consolidate your finances
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