As context, we resided in the United States from 2000 to 2009. Currently, we are Indian residents and Indian citizens (U.S. non-resident aliens). Through 4-5 years of employment in the US, we have a 401(k) account held in the U.S. (earned during years of employment and residency within the U.S.). We are now seeking distributions (full payouts) from the above-mentioned account and wish to do so in a tax-efficient manner, invoking the tax-treaty between the U.S. and India. We have been told by our 401(k) managers that there will be zero withholding of tax from the 401 (k), given our status as Indian residents/citizens and the existence of India-US tax treaty (assuming we complete the W8-BEN form proving our resident status in India). Our questions are as follows:

- Is the distribution of 401(k) in our case truly exempt from U.S. taxes and penalties, given this income tax treaty?
- Which article of the treaty specifically covers this distribution?
- If we do not have any income in the United States and do not qualify as a resident of the US, do we still need to file income tax return given we are taking a distribution of the 401(k) account?

No, it is NOT tax-exempt. The 401K pension is tax-deferred, which means it was funded with pre-tax money, with the understanding that taxes would be due on both principal and interest/dividends/capital gains when the money is distributed at some future date.

There is nothing in the U.S.-India Tax Treaty that exempts 401K or IRA distributions. That being the case, it is considered to be "other income: under article 23 of the U.S.-India Tax Treaty, and, for this reason, the distribution is subject to taxation under the laws of the United States.

Now, if you take an early distribution (before age 59.5), you are subject to normal income taxes PLUS a 10% Early Withdrawal Penalty. Given these facts, the 401K custodian will withhold 30% of the distribution to cover the tax and the 10% Early Withdrawal Penalty.

You WILL have to file a non-resident alien tax return (Form 1040NR) to account for the distribution. Since it is considered deferred compensation, you will be taxed at the progressive tax rates (first 10%, then 15%, then 25%, then 28%, then 33%, then 35%, under current tax laws).

Since you will be taxed at progressive rates, you WILL be allowed to claim a personal exemption (currently $3,650). If you waited until you turn 59.5 years of age, then withdrew only an amount equal to the personal exemption at that time (it goes up every year), you could then withdraw the money effectively tax-free.

I agree with ATE that the distribution will be taxable and that the treaty will not apply to prevent U.S. taxation.

I would add one refinement. The distribution from the 401(k) represents the original contributions as well as the earnings on those contributions. Distributions attributable to the original contributions are taxed at U.S. graduated tax rates as ATE describes above. However, distributions attributable to the earnings (sometimes referred to as "earnings and accretions") are taxed at a flat 30% tax rate.

IntlTax:

It has been awhile since you have posted. Vacation?

You are correct about the 30% flat tax on the earnings, though, given how flat dividends and other earnings have been the last few years, very little will be taxed at 30%.

ATE and IntlTax:

Thank you for your prompt responses - these are very helpful. I just have 3 follow-up comments/questions:

1. Why are Fidelity and Hewitt agreeing to withhold 0% income tax and no penalty, if the treaty is not applicable?

2. Do I need to fill out a W8-BEN form?

3. Going by what you are suggesting, can I ask my 401(k) manager to withhold just enough taxes based on my calculation of marginal tax brackets or will they automatically withhold 30% no matter what?

Thank you again for your help on this matter. Very much appreciated.

1) Ignorance.

2) Yes.

3) Should be 30% no matter what.

Dear ATE,

Following from your last exchange re: W8-BEN, isn't W8-BEN to befilled out only for income which is NOT effectively connected with a U.S. trade or business (401-K is indeed effectively connected, I believe)? Instructions on the BEN form point to W8-ECI for income that is effectively connected as a foreign person.

Only exception I can see is that W8-BEN can still be used for non-effectively connected income (i.e. 401-K) only IF we are claiming treaty benefits (which, as an Indian technically we are per Article 23 although the U.S. still has the right to tax, and it will... if I am following your responses above accurately).

So, in summary, is W8-BEN appropriate to fill out given the situation described above? Or is W8-ECI the right one to fill out? I guess in the end it doesn't matter since you will still pay the same amount, although its important to get the withholding right I suppose (Fidelity says 0% for W8-BEN out of ignorance!)

Would appreciate your expertise on this - thank you in advance!

Use the Form W-8ECI for this case; it may have the effect of jarring both Hewitt and Fidelity to better research the law and make the correct decisions.

HI ATE and IntlTax,

I am also in the same situation. I came through other publications and it was mentioned that Capital Gains and Dividends are taxed at 30% whereas principal is just taxed at normal tax slab rates for that year.

For e.g. I had invested around $60000 both including Employee and Employer contribution and have lost around $10000 in the account during the recession so had only loss at the end. I rolled all the amt to Traditional IRA. Then converted $37000 to Roth IRA in Dec 2010 to get the 2 year tax spread advantage. I did withdraw $13000 from traditional IRA.

In the 1099 R nothing was mentioned related to Dividend and I am sure that I did not make any money instead I lost.

I will file taxes for 13000$ - year 2010 - Personal exemption 3700, 10000 for Primary home- So no tax and Penalty will be for 3000 only which is 300
I will file taxes for 18000$ - year 2011 - Personal Exemption - 3700 remaining taxes and penalty

I will file taxes for 18000$ - year 2012 - Personal Exemption - 3700 remaining taxes and penalty

Thanks Again for wonderful site.

Regards
Viji

Also is there any deadline to send the W8BEN form and what is the implication of not sending the form. I came to india on Nov 2009. Can I still send the W8BEN form to US.

Please Advise.

Thanks
Viji

Vijis-

Based on my research and the responses above from ATE and IntlTax, here is my understanding:

1. Plan providers should withhold 30% if you are a non-resident alien.
2. You need to independently file your taxes (1040NR) and the same will be determined based on marginal tax rates, since it is effectively connected income.
3. There is no need for a W-8BEN, since the treaty does not apply toward withdrawal of 401(k) contribution. Also, W-8BEN is to be provided to the plan administrator, so they can detemine your tax status for withholding.
4. If you have RNOR status in India, you will not have to pay taxes once you bring that income home.

Hi Indian_Spring,

Thanks for the detail explanation.
My comments below for each answer.

1. Plan providers should withhold 30% if you are a non-resident alien.

Fidelity was the Plan provider but they did not with hold 30% I think as it was mentioned already it is due to ignorance

2. You need to independently file your taxes (1040NR) and the same will be determined based on marginal tax rates, since it is effectively connected income.
OK got it. I am doing the same. Which will be just 10 % bracket.


3. There is no need for a W-8BEN, since the treaty does not apply toward withdrawal of 401(k) contribution. Also, W-8BEN is to be provided to the plan administrator, so they can detemine your tax status for withholding.
For the past 3 momths, I am getting letter from Fidelity to fill the form and send it back to US. Should I ignore that then.

4. If you have RNOR status in India, you will not have to pay taxes once you bring that income home.
I understand this. Unfortunately, I am not in RNOR status as per the excel with few days missing as I came to India 2 times for vacation during my 5 years stay in US.

But even though not in RNOR status , I heard that Indian tax is application only on amt that relates to capital gains and Dividends and not to Principal as I have paid interest already for this.

Is that correct?

Also, ATE has answered YES for your question below.

2. Do I need to fill out a W8-BEN form?

Thanks Again.
Viji.S