How to treat nonresident aliens for qualified retirement plan purposes is often misunderstood.  Are nonresident aliens allowed to participate in U.S. plans?  Do you have to cover them?  And what is a nonresident alien anyway?

Nonresident Alien Defined

A nonresident alien is someone who is not a U.S. citizen and who either does not have a green card or does not meet the substantial presence test.  Under the substantial presence test, you are a resident for federal tax purposes if you lived in the U.S. for 31 days in the current year or 183 days in the last three years.  For the 183-day test, some days in the first two years of the three are not counted.

This means a worker who was born and raised in another country but now lives in the U.S. with a green card is a resident alien, not a nonresident alien.  Likewise, a worker who comes to the U.S. for six months and then returns to his home country is also a resident alien for that year.

Also Need to Know Whether There Is U.S. Source Income

Even if we determine that a worker is a nonresident alien, we are not finished yet.  We also need to know whether the nonresident alien has U.S. source income.  The definition of U.S. source income is a bit cumbersome.  In a nutshell, income earned by a nonresident alien for work performed within the U.S. is U.S. source income.

What this means is that someone who comes to the U.S. from a foreign country and works here probably does not need any special treatment under the nonresident alien rules, since they almost surely are not nonresident aliens with no U.S. source income.

Does this mean that all nonresident aliens with U.S. source income have to be covered in U.S. qualified retirement plans?  No.  If a company would like to exclude nonresident aliens from its plans, it certainly may.  It’s just that nonresident aliens with U.S. source income are not excludable employees under Internal Revenue Code Section 410(b).  Such employees cannot be disregarded under coverage and nondiscrimination rules.  Rather, they are included in these compliance tests as “not benefitting.”  This is not a problem unless coverage or benefits unduly favor Highly Compensated Employees.

Rules Apply When There Is a Foreign Parent or Subsidiary

So far, we have talked about when the nonresident alien rules don’t apply.  When do they apply?  Here is an example.  Suppose USA Company here in Virginia sponsors a 401(k) plan with 20 participants.  USA Co. is wholly owned by EUR Company in Europe which has 40 employees.  Because of the 100% ownership by EUR Co., the two companies are considered a controlled group and are generally treated as one employer under the U.S. pension rules.

USA Co. does not want to include the EUR Co. employees in its 401(k) plan.  None of the EUR Co. employees have ever been to America except on vacation or to check on USA Co. for a week at a time.  They do all their work in Europe and are paid in euros.  Accordingly, all of the EUR Co. employees are nonresident aliens with no U.S. source income.  Not only does the USA Co. 401(k) plan not have to include the EUR Co. employees, the EUR Co. employees can be ignored for coverage and nondiscrimination testing.

Note that there is nothing stopping a U.S. company from including nonresident aliens with no U.S. source income in its retirement plan.  They are still excludable employees for coverage and nondiscrimination purposes and therefore neither help nor hurt in those tests.

Most U.S. Companies Not Affected

Most companies in the U.S. will never have to think about the nonresident alien rules.  The majority of others will find that the rules simply allow you to disregard foreign employees that the U.S. company never would have thought about covering to begin with.

Additional Tax Withholding Is Required

In closing, we should point out that additional tax withholding is required for pension distributions made to nonresident aliens.  Generally, eligible rollover distributions from qualified retirement plans that are not in fact rolled over are subject to a mandatory 20% withholding for federal tax.  For nonresident aliens, plans are generally required to withhold 30% of the payment for federal income taxes.