A Guide to Managing 401K When Moving Back To India

One of the most common questions I get asked is what to do with our 401K or retirement accounts after moving back to India from USA? Should you withdraw your 401K, convert it to Roth or let it sit until retirement? Is 401K taxed in India after moving back? Can you withdraw 401K from India? I will attempt to summarise what I know about this topic, answer some frequently asked questions and the approach we followed after returning to India. We were on H1-B and are citizens of India (this is important since taxation is different for US citizens and green card holders). Please note that even though we followed the approach outlined below, this may not be the best strategy for you since that will depend on the amount you have, what you plan to do with it and how comfortable you are leaving it in the US. Your individual circumstances will vary so please decide accordingly.

Disclaimer: I’m not a financial advisor or a CA and the below advice is not meant to be financial or tax advice. The information below is based on talking to CAs in both countries, learning from the experiences of others and reading from public forums and meant to serve as guidelines on how you can think about your retirement accounts. Please consult your tax advisors for complete assistance.

What is a 401K?

For those of you who are unaware of what 401K is, it is an account (similar to PPF in India) that companies use to provide retirement benefits to employees. A certain percentage of your salary gets deposited into this account and the company typically matches this percentage. In other words, the company contributes the same percentage of your salary into this account.

For example, let’s say your salary is $100,000. Your company might offer you a 100% match rate up to 3%. That means that every year, you will put in $3,000 and your company might also put in $3,000. These amounts are now invested into financial instruments of your choice. The biggest advantage of this account is that the contribution is made on pre-tax dollars which means that your account compounds at a much faster rate. 

So, what is the catch? The catch is that you can only use that money after retirement at 59.5 years of age. If you want access to that money, you need to pay the taxes (you owe taxes because the amount was deposited pre-tax) and an additional 10% early withdrawal penalty. If you are a high earner and have significant savings, this may result in 30-40% of your money being wiped away.

Before we jump into what to do with your 401K, there are a few terms you should be aware of.

USA

• Resident Alien: These are typically people who are US citizens, green card holders or working professionals on H1b who have spent some time in the USA in the last three years.
• Nonresident Alien: These are mostly students or people who don’t reside in the USA long enough to be treated as residents. Most Indians who have moved back to India, do not have green cards and are not citizens of the USA fall under this bucket.

Source: IRS

India

• Resident: These are people who reside in India for most of the financial year. You are treated as a resident of India if you have spent more than 182 days in a financial year OR have been in India for more than 60 days in the financial year AND more than 365 days in the last four financial years.
• Nonresident: If the above does not apply, then you are treated as a non-resident.
• Resident But Not Ordinarily Resident (RNOR): This is a special status mostly designed for people who come back to India after living abroad. You are said to be in RNOR status if
  • You have been a non-resident in India for the last nine out of ten financial years. OR
  • You have been in India for less than 729 days in the last seven years.

Source: Government of India

The RNOR status comes with the benefit that your income, capital gains or dividends outside of India are not taxable in India. If you plan to withdraw your 401k before the retirement age, you can use this status for one of the strategies.

What to do with your 401K when you move back to India?

When you decide to move back to India, you naturally want to decide what you want to do with your 401K account that minimises taxes and penalties. There is also an additional complication of taxes and penalties in India since you will become a resident of India for tax purposes. If you have been working for a long time, your 401K is probably a significant amount. You need to figure out a way to minimise your tax burden in India and the USA. 

There are a few different choices you have:

Choice 1: Withdraw the 401K/IRA after you move back to India

What is the total tax and penalty you would pay if you withdraw your 401k after moving back to India before 59 years?

If your 401K amount is less than $100K, you can withdraw it earlier than 59 and end up paying <25% total tax, if you do it in the RNOR period. This is the strategy we followed when we moved back to India. The $100K number is an example and the strategy can be used no matter what your withdrawal number is. If your withdrawal amount is higher, your tax brackets will change accordingly.

Step 1: Rollover your 401K to IRA (Individual Retirement Account)

Why do you need to rollover your 401K to IRA? 

There are a few advantages of the IRA account:

1. Typically, an IRA has far more investment options than a 401K. Since your 401K account is tied to your employer, the investment options are limited. If you change your mind about withdrawing your retirement account, having the funds in an IRA gives you much more flexibility than a 401K.
2. IRA accounts usually have no administrative fees. I know that Fidelity does not charge any fees to maintain an IRA account.
3. Both 401K and traditional IRA are treated the same from a taxation perspective. Transferring money from 401K to IRA is a non-taxable event.

Which brokerage should I open the IRA account with?

I have had a great experience with Fidelity and would recommend opening one with them. They allow international address and support non-residents. Make sure to open one while you are in the US.

Can I open an IRA while being employed with my US company?

Yes, an IRA can be opened while being employed. I recommend opening one while in the US. However, you can not move your 401K to an IRA while being employed with your company. You can open an IRA and fund it after you leave your job. For us, our 401K and IRA were both at Fidelity and we asked Fidelity to move the money to IRA after moving back to India. They did it electronically without any need for checks.

Is the taxability of IRA different than 401K?

No, both IRA and 401K are taxed the same way.

Step 2: Figure out your residential status in India as well as in the US

Based on the number of days you have spent in the US or India in the past few years, you will be eligible for NRI/RNOR status after moving back to India. You can follow the official Government of India document for Indian residential status and the IRS website for the US residential status. My wife and I both were in RNOR status for two financial years after coming back to India.

Step 3: Submit form W-8 BEN to your broker once you are in RNOR or resident status

W-8 BEN form is to let your broker know that you are no longer a US resident. This is important from a tax filing perspective since forms and tax withholding for US residents are different than for Indian residents. Also, the amount of tax withheld is different. Fidelity lets you submit this form online.

Step 4: Withdraw your IRA in parts when you are in RNOR status to minimize tax burden.

How does this withdrawal work?

Let’s understand this with the help of an example. Below are some approximate numbers.

Assume that you have $70,000 in your 401k that you have rolled over to an IRA. Let’s say you are going to be in RNOR status for two years after you return to India. Here is one way you can withdraw from traditional IRA and keep your total liability down to less than 25%.

Year 1 of RNOR:

• Withdrawn Amount: $35,000

• India Taxes:
  • Residential Status – RNOR
  • $0 since India does not impose a tax on US income during the RNOR period. Of course, you will be paying tax in India on any salary earned in India.

• US Taxes:
  • Residential Status: Non-Resident
  • Federal Tax: $3980 (10% to $11,000, 12% on amounts between $11,000 and $44,275)
  • State Tax: $0 since you are no longer a resident of any US state
  • Penalty: 10% of $35,000 = $3,500

Total tax liability: $7,480 which translates to roughly 21.4%.

Year 2 of RNOR:

• Withdrawn Amount: $35,000

• India Taxes:
  • Residential Status – RNOR
  • $0 since India does not impose a tax on US income during the RNOR period. Of course, you will be paying tax in India on any salary earned in India.

• US Taxes:
  • Residential Status: Non-Resident
  • Federal Tax: $3,980 (10% up to $11,000, 12% on amounts between $11,000 and $44,275)
  • State Tax: $0 since you are no longer a resident of any US state
  • Penalty: 10% of $35,000 = $3,500

Total tax liability: $7,480 which translates to roughly 21.4%.

In total, you will end up paying $14,960 on a total of $70,000 which translates to 21.4% (including taxes and penalty).

Are there standard deductions for non-residents?

No, there are no standard deductions for non-residents.

Can I file married jointly?

No, as non-residents you will have to file separate returns.

I read somewhere that non-residents are charged a 30% tax in the US. Is this true?

The answer to this question is complicated and depends on the type of income in question. There are two types of income – 1) Effectively Connected Income: This income is generally the income you earned when working in the US. 2) Fixed, Determinable, Annual or Periodical (FDAP): This is mostly income from interest, dividends etc. The below information is from the IRS website which states that FDAP is taxed at 30% whereas ECI will be taxed at the same graduated rates even for non-residents.

Source: IRS

The difference between the taxation of these two types of incomes is that ECI is taxed at graduated slab rates (the way your salary in the US got taxed) whereas FDAP is taxed at a flat 30% for non-residents. The key is in understanding whether your 401K/IRA money is ECI or FDAP. The below is what the IRS website says:

Source: IRS

Your 401K income was earned when you were working in the US. The above link says that “the income you receive in another tax year from the performance of services is treated as effectively connected in that year, if it would have been effectively connected in the year the transaction you performed services.” Your 401K/IRA money was earned when you performed services in the US. Based on the above, it should be treated as ECI and hence taxed at normal income slab rates and not 30%.

In my research, I have read conflicting opinions on the above interpretation with some folks still interpreting 401K/IRA as FDAP and some as ECI so it’s best to still confirm it with a CPA.

My broker told me that they would charge 30% tax when withdrawing my IRA. What should I do?

Despite submitting W8-BEN, Fidelity decided to withhold 30% of my 401K. Don’t worry too much if this happens. Understand that they are only withholding 30%, it does not mean that your tax is 30%. You can always claim it back when filing your returns.

Choice 2: Keep the 401K until retirement

Keep the 401k as it is until you retire and withdraw it after you turn 59.5 years of age. Remember that since you will be a resident of India for tax purposes, you will have to figure out your tax liability in India in the future. This is a good option if you think your taxes will be lower in retirement. The risk you run is that tax laws and brackets can change over time and there might be uncertainty over tax treatment in the future. Also, talking to CAs after coming back to India, I realised that tax laws are a bit unclear in India for treating foreign retirement accounts.

Another real risk is estate taxes. These are taxes that USA will levy in case of your death. For residents, the limit is about $12M so it is less of a concern. But, for non-residents, the exemption is only up to $60,000 which is easy to hit. That means that any amount above $60,000 will be subjected to estate taxes of 18-40%. This is a real and often overlooked risk. Source: IRS

Choice 3: Convert to Roth IRA

Converting to Roth is also an option where you can pay minimum tax in the US in a couple of years (when you are in RNOR in India) when you don’t have US income. Then, after five years you can withdraw the principal tax and penalty-free in the US. However, since your RNOR status would have expired, the capital gains and dividends are subjected to taxes in India (but not the principal). This is a good approach to save on the 10% penalty and can be followed if you don’t want access to the money for a few years. My understanding is that there is some lack of clarity regarding the taxation of Roth IRA in India outlined here. We personally did not follow this approach so I don’t have step-by-step guidance but it may work out better for you especially if your amounts are much higher.

We evaluated the pros and cons of all the options and went ahead with option 1. We withdrew our 401K after converting it into a traditional IRA. Yes, the popular opinion is to not touch it until retirement. There might have been some other strategies (like Roth IRA) that may have reduced our tax liabilities even further. But, at ~22% total tax and penalty, we did not find strategies worth the other compliance headache that comes with it. This topic is also one where I have read the most conflicting opinions. The more I talked to CAs, the more I realised that some of these rules are open to interpretation and for us, it felt like more trouble than it’s worth to maintain these retirement accounts. CAs also charge a lot more to file taxes in India when it comes to staying compliant with respect to retirement accounts. We also felt more at ease knowing that we don’t have to deal with complicated taxes every year and risk going wrong. The final decision we took was to withdraw our retirement accounts completely when we were in RNOR status in India and non-resident status in the US.