401(k): What is it? How are 401(k) withdrawals taxed for non-residents?

A 401(k) plan is a retirement savings plan offered by many American employers that has tax advantages for the saver. If an employee joins a 401(k), he or she agrees to contribute a percentage of their paychecks directly to the investment account. A portion or all of that contribution may be matched by the employer.

If you are a citizen of another nation who stays in the United States for work purposes on a visa, you may be labeled by the IRS as a nonresident alien. This classification is applied to foreign nationals who do not have a U.S. green card or fail to meet the substantial presence test criteria. Nonresident aliens must only pay income tax on money earned from American sources. Many nonresident aliens choose to invest in 401(k) retirement plans given by their employers in this country, however this can present an issue when going home afterwards.

For both U.S. residents and nonresident aliens, withdrawal of funds from a traditional or Roth 401(k) before reaching the age of 59½ or becoming permanently unable to work due to disability is not allowed by the IRS. If you choose to cash out your funds prior to this milestone, you will be subjected to an additional 10% penalty as well as complete taxation of your 401(k) withdrawal by the U.S., irrespective of where you reside when receiving these funds.

The funds from a 401(k) withdrawal can be transferred to another tax-advantaged account, such as an individual retirement account (IRA), to reduce tax payments. If you roll your 401(k) over to an IRA directly, you’ll avoid the 10% early withdrawal penalty. You must first open the IRA and then fund it with your 401(k).

There is still a 10% tax penalty if you take a distribution from your IRA before you reach age 59.50, but there are more exceptions, such as unreimbursed medical expenses, first-time homebuyers, disability, etc.