Tax-Expatriation

How the U.S. imposes income taxes on Social Security retirement benefits on former USCs and LPRs who reside outside the U.S.

Posted on May 26, 2014 Updated on May 27, 2014

Previous posts have explained how the Social Security Law and the U.S. federal tax law are different bodies of laws that have different rules for U.S. citizens who renounce and LPRs who formally abandon their permanent residency status.

See, Why vested Social Security Retirement Benefits are not lost when a USC or LPR sheds their citizenship or immigration status. The Answer to: What happens to social security benefits to former USCs and LPRS including a “covered expatriate”?

This post explains the unique U.S. federal income tax treatment of social security retirement benefits.  The tax treatment is different for USCs and former USCs who reside outside the United States.

• Former U.S. Citizens (25.5% Withholding Tax on All Amounts) – NO Graduated Tax Rates
  

Former USCs who reside outside the U.S. become “nonresident aliens” and hence are subject to a withholding tax that reduces the net Social Security benefits.  The U.S. federal government withholds the tax immediately on all Social Security retirement payments to nonresident aliens at a 25.5% rate (calculated under the statute as 85% of the normal 30% statutory rate).  See, IRC Section 871(a)(3).

The IRS form used for withholding is SSA-1042S – Social Security Benefit Statement.

For instance if a monthly Social Security retirement payment is US$2,000 (gross), the tax withholding of 25.5%. creates a total tax withholding of US$510 (25.5% x US$2,000).  This leaves a net retirement payment of US$1,490 that will be received by the former U.S. citizen.  In relative terms, this is a very high effective tax rate, i.e., 25.5%, particularly considering in this example the former USC has only US$24,000 of annual Social Security retirement payments.

The same withholding tax rate applies if the former USC has millions of dollars of annual income, or no other sources of income;  25.5% – period.

•  Current U.S. Citizens (0% Withholding Tax) – May or May Not be Taxable Depending Upon Total Income
  

There is no withholding tax imposed upon current USCs on Social Security retirement payments.  However, there is an income tax that may be levied on a portion of the Social Security retirement payments, depending upon the total income of the individual.  Basically, a USC needs to have more than US$25,000 of income annually, for any of the Social Security retirement income to be subject to U.S. income taxation. There are important detailed rules, where “modified adjusted gross income” is used to help make this determination of the so-called “base amount.”

See, IRC Section 86 for the specific statutory rules which provide that 50% of the Social Security retirement income is subject to taxation if the individual has an “adjusted base amount” of US$25,000 or more ($32,000 in case of a joint return).

The Social Security website describes this statutory rule in layman’s terms –

• Some people have to pay federal income taxes on their Social Security benefits. This usually happens only if you have other substantial income (such as wages, self-employment, interest, dividends and other taxable income that must be reported on your tax return) in addition to your benefits.

Once the “adjusted base amount” exceeds US$34,000 or more, then 85% of the Social Security retirement income is subject to taxation ($44,000 in the case of a joint return).

In the example used above of the US$24,000 of annual Social Security retirement payments, this income level will create no U.S. federal income taxation to a USC (not a former USC) if he or she has no other income.

In contrast, the former USC will have had indirectly paid (via the tax withheld), a total annual federal income tax of US$6,120 on the same amount of Social Security retirement benefits;  US$24,000.

For the discussion of the IRS, explaining these rules, see Publication 915.

Finally, and most importantly for residents of certain countries (e.g., Canada), an income tax treaty with a specific provision can modify these rules in certain circumstances.  Later posts will be dedicated to how these rules can be modified by an income tax treaty provision.  Income tax treaties are not to be confused with Social Security Totalization Agreements.  See, Social Security Retirement Benefits – for former USCs and LPRs (Intersection of U.S. Tax and Social Security Law)