US Taxation of Italy Pension Plans
US Taxation of Italy Pension Plans: As with many foreign countries, the Italian pension system follows the common three (3) Pillar structure, which combines State, Occupational, and Voluntary Pension schemes. In accordance with the World Bank Pillar framework (which recently transitioned from a three pillar to five pillar system), the Italian pension system has three components to it:
- Pillar 1: State Pension Scheme
- Pillar 2: Occupational Pension
- Pillar 3: Voluntary Pension System
In general, the Italian Pension system has been going through changes, including increasing the age of retirement, and modifying early retirement — and how the pension system works in general.
Generally the Pillar 1 is characterized as social security, while Pillars 2 and 3 are treated as “pension.”
The first part of the article will summarize how Italy Pension is taxed n the U.S.
Reporting on FBAR, FATCA, 3520, and 8621
Beyond the US tax liability of an Italian pension, is the equally complicated concept of reporting the pensions. Foreign pensions may be reported on various forms, such as:
- FBAR (FinCEN Form 114)
- Form 8938 (FATCA)
- Form 8621 (PFIC)
- Form 3520 (Trust)
We will summarize if an Italy Pension Plan Taxable in the US, and how the reporting rules work.
Pillar 1 (Social Assistance)
Pillar 1 is social assistance, and is similar to U.S. Social Security. And, just as social security payments by individual taxpayers (non self-employed) are not deductible on their U.S. tax returns, contributions to the public pension (Pillar 1) are not deductible either.
The amount of contributions for each taxpayer are based done the earning capacity of the taxpayer. There are different tax rates, including a minimum threshold a person must earn in order to have to contribute.
Individuals do not have specific ownership of their contribution portion as they do with a Pillar 2 or Pillar 3 pension, like a 401K plan or IRA.
The U.S. and Italy have entered into a Totalization Agreement. The agreement prevents the taxpayer from paying into two social security systems.
As provided by the Agreement:
Under the terms of the agreement, a national of the United States or Italy who would otherwise be covered by both countries, will generally remain covered only by the country of which he or she is a national and is exempt in the other.
However, Italian nationals and dual nationals (nationals of both the U.S. and Italy) who are working in employment or self-employment covered by both systems must elect to be exempt from coverage and taxation under one system and to pay Social Security taxes to the other.
This election must be made within three months from the date the work begins.
Therefore, while payments the Italian Social Security/Assistance system is not deductible, a U.S. person working in Italy does not have to pay into both systems.
Pillar 2 (Occupational Pensions)
Pillar 2 is the occupational pension in Italy, which is funded through employment.
Privatized voluntary pension plans are not as common in Italy as they are in other countries.
Some industries have had private occupational plans before certain provisions were introduced into law, but with the recent changes to the Italian Pension Scheme Law, Italy is seeking to bolster Pillar 2 and 3 pensions.
There are various categories of pensions in Italy that are considered Pillar 2.
Some of the programs are funded through agreements in specific areas of industry, and other fund are funded developed through various foreign institutions.
In Italy, the employee can deduct the contributions to the pension fund up to a certain amount (generally about $6000 USD).
The taxation rules are detailed below under the Treaty analysis portion of this article.
Pillar 3 (Private Pensions)
Pillar 3 is for Individual Pension Schemes, which do not have to specifically associated with an employer.
In other words, these types of individual pensions are not facilitated through employment, but are rather individual (non-occupational) pension schemes (PIPs).
There is no specific employment limitation or requirement, and are generally considered “open” types of pension plans.
U.S. Italy Tax Treaty (Article 18 Pension)
The Tax Treaty between the U.S. and Italy on the issues of Pensions is well-suited for cross-border taxpayers.
Let’s go through it:
The treaty sets out various pension distribution rules under Article 18.
Article 18, Paragraph 1 (General Provision)
“Subject to the provisions of paragraph 2 of Article 19 (Government Service), pensions and other similar remuneration beneficially derived by a resident of a Contracting State in consideration of past employment shall be taxable only in that State.”
This paragraph is bit less specific than in other treaties, but is then clarified in the subsequent paragraphs below.
It basically provides that if a Taxpayer receives pension while a resident of a contract State (U.S.) for consideration of past-employment is taxable only in that state (U.S.), and vice versa.
Article 18, Paragraph 2 (Social Security)
“Payments made by a Contracting State under provisions of the social security or similar legislation of that State to a resident of the other Contracting State shall be taxable only in the other State.”
Unlike many other treaties that limits tax on social security to the country of source, this section is written differently.
Thus, social security payments made by a contracting state (Italy) to a resident of other the state (U.S.) shall be taxable only in the other state (U.S.)
Article 18, Paragraph 3 (Lump-Sum and Severance)
“Notwithstanding the provisions of paragraph 1, if a resident of a Contracting State becomes a resident of the other Contracting State, lump-sum payments or severance payments (indemnities) received after such change of residence that are paid with respect to employment exercised in the first-mentioned State while a resident thereof, shall be taxable only in that first-mentioned State.
For purposes of this paragraph, the term “severance payments (indemnities)” includes any payment made in consequence of the termination of any office or employment of a person.”
This paragraph clarifies paragraph 1 and provides that if for example, a resident of Italy, becomes a resident of the U.S., then lump sum payments or severance are only taxable in Italy (and vice versa).
Article 18, Paragraph 4 (Annuities)
“Annuities beneficially derived by a resident of a Contracting State shall be taxable only in that State.
The term “annuities” as used in this paragraph means a stated sum paid periodically at stated times during life or during a specified number of years, under an obligation to make the payments in return for adequate and full consideration in money or money’s worth (other than services rendered).”
This paragraph also clarifies paragraph 1 and provides that pension annuities derived by a resident of Italy (for annuities sourced from Italy) are only taxable in Italy.
Article 18, Paragraph 5
Alimony and child support payments paid to a resident of a Contracting State by a resident of the other Contracting State shall be taxable only in the first-mentioned State. However, such payments shall not be taxable in either State if the person making such payments is not entitled to a deduction for such payments in the State of which he is a resident…
*This paragraph refers to alimony and child support payments and beyond the scope of this article.
Pension Contribution Deductible for US Tax
Article 18, Paragraph 6
For purposes of this Convention, where an individual who is a participant in a pension plan that is established and recognized under the legislation of one of the Contracting States performs personal services in the other Contracting State:
(a) Contributions paid by or on behalf of the individual to the plan during the period that he performs such services in the other State shall be deductible (or excludible) in computing his taxable income in that State. Any benefits accrued under the plan or payments made to the plan by or on behalf of his employer during that period shall not be treated as part of the employee’s taxable income and shall be allowed as a deduction in computing the profits of his employer in that other State.
(b) The provisions of this paragraph shall apply only if:
(i) contributions by or on behalf of the individual to the plan (or to another similar plan for which this plan was substituted) were made before he arrived in the other State; and
(ii) the competent authority of the other State has agreed that the pension plan generally corresponds to a pension plan recognized for tax purposes by that State.
The benefits granted under this paragraph shall not exceed the benefits that would be allowed by the other State to its residents for contributions to, or benefits otherwise accrued under a pension plan recognized for tax purposes by that State.
What does it Mean?
This paragraph is similar to the UK treaty, and it helps Taxpayers immensely.
It basically provides that, for example, contributions paid for a U.S. Person who is working in Italy and receiving pension contributions shall be deductible on their U.S. tax returns.
FBAR, FATCA, 3520 & 8621 Italy Pension Reporting
There are many IRS International Information forms to consider when reporting the Italian Pension to the IRS.
With the IRS taking an aggressive position on matters involving foreign accounts compliance and unreported offshore income — it is important to stay compliant with the Internal Revenue Service rules and requirements.
Since the US and Italy have entered into several tax treaties such as the Double Tax Treaty, FATCA Agreement, and Totalization Agreement there are complex rules involving which country can tax the pension – usually based on residency and which Pillar is at play.
Since the Pillar 1 is social security equivalent, it is generally not reportable, as it is not an individualized funded accounts.
As to Pillars 2 and 3, here are some of the basics:
Italy Pension Plan & FBAR
The FBAR Is used to report foreign bank and financial accounts, including life insurance, investment account, etc.
Generally, while Pillar 1 (Social Security) is not considered FBAR reportable — since it is equivalent to U.S. Social Security and not technically an account — the same cannot be said for other pillars.
Pillar 2 (Occupation) or Pillar 3 (Private) are reported on the FBAR since they are segregated accounts for each person who contributes, and the accounts have a separate identifier and value based on the contribution amounts.
FATCA Form 8938 & Italy Pension Plan
The IRS Form 8938 (FATCA) form is required for certain U.S. Taxpayers to report specified foreign financial assets.
The FATCA reporting (for U.S. Taxpayers) was introduced on the 2011 tax returns, and is technically referred to as the Foreign Account Tax Compliance Act.
Foreign Pension & Retirement is considered a foreign asset for FATCA purposes and therefore would be reportable on a Form 8938.
Generally, the same rules would apply as for the FBAR, insofar as Pillar 1 may escape reporting, but Pillars 2 and 3 are reportable.
Form 3520/3520-A & Italy Pension Plan
Form 3520-A/3520 is used to report Foreign Trusts. At its most basic, a pension such as an Italy Pension is foreign trust:
- Government Trustor (Pillar 1),
- Employer Trustor (Pillar 2)
- Investor/Employee (Pillar 3)
And, each trust has an Administrator, along with the employee beneficiary.
Thus, technically, the Italy Pensions are a Trust.
Pillar 1: 3520-A
Pillar 1 is State mandated (State) which most resembles U.S. social security. It has no identifiable segregated balance, and the beneficiary (employee) is not the owner of the trust.
Presumably, the trust would not be reportable on Forms 3520/3520-A.
Pillar 2: 3520-A
There is no concrete ruling by the IRS on the reporting for the Italy Pillar 2 and 3 pensions on the Form 3520-A. Generally, unless the employee has contributed more to the pension plan than the employer has, it is not reported on Forms 3520, since the beneficiary is not the owner of the trust during the years the beneficiary is employed and funding the pension.
In addition, it may qualify for a Revenue Procedure exception under Rev. Proc. 2020-17, depending on the person’s salary, age (determines percentage contributions), voluntary vs. mandatory, and employed vs. self-employed.
Pillar 3: 3520-A
Italy Pension Pillar 3 is completely optional and voluntary.
Therefore, chances are this is a foreign trust which would be subject to Form 3520-A Reporting (Rev. Proc. 2020-17 may exempt reporting)
In addition, some clients will take the position that it is still a form of pension vs. pure investment, and therefore while it is in the growth phase, and deductions are not being taken, it is can escape reporting.
Form 8833 is used by Taxpayers who want to take a Treaty Position on issues involving the applicability of tax rules when it involves the pension (and other tax related matters).
Form 8621 is used to report PFIC (Passive Foreign Investment Companies). It also includes Foreign Mutual Funds. Generally, Pillar 1 is not reportable, but Pillars 2 and 3 would be.
With PFIC, the main question will become whether the PFIC requirement (presuming the investments have funds in them), are reportable during the growth period (pre-distribution), or only once the pension becomes active/accessible.
That is a strategy issue each person should discuss with their counsel.
If you have not properly reported your Italy Foreign Pension in the U.S. for tax, FBAR, FATCA, PFIC (8621) or other reporting, you may be out of compliance and possibly subject to fines and penalties.