Wednesday, November 12, 2014

How to Run Away from a Keren Hishtalmut

The blog returns this week after a longer-than-expected unexpected delinquency. Fortunately, Bituah Leumi is being kind enough to sponsor 11 weeks of paternity leave which will allow me an extraordinary amount of time to ponder important financial issues while changing diapers. In fact, I plan to honor this unprecedented leave from work with a special blog in which I will share my personal tips on how to save money running your household.

But first, in this final blog about whether the Keren Hishtalmut is a PFIC, I present you with Investing by Accident’s not-at-all-proven methods for running away from the PFIC inside of your Keren Hishtalmut. Also, by a horrible act of ill-luck, you can also use the same methods to run away from the PFIC inside of your Israeli pension.

Method #1: Renounce Your Citizenship

Renouncing your U.S. citizenship is like selling your apartment and moving to a big house in a far-off place where no one wants to live in order to save a lot of money. It is really popular to talk about with your Friend, but no one actually does it.

Frankly, it would be very un-American to renounce your citizenship. I can’t even consider it because there is no one who is more American than me. Well, except perhaps for Americans who still live in America and don’t talk renouncing their citizenship on their blog.

In any case, this would only be a forward looking solution. You would still need to pay taxes for the years up until you renounce your citizenship.

Method #2: Temporary Regulations

The regulations published by the IRS are “temporary,” which is an English word that is generally used to refer to something that is not yet permanent. I’m not sure that it means the same thing in IRS-English, but the bulletin includes a contact phone number: (202) 317-6934.

I suppose you could call the number and ask them to change the regulations. Please let me know what they say.

Method #3: Update the Tax Treaty

I am already planning to speak with John Kerry about the tax treaty next time he is in the region. I will ask how he feels about designating Israeli pensions for special treatment as if they are U.S. qualified plans. If we could this, we could escape the PFIC inside of the Israeli pension plan. There is no harm in asking him if we would be open to do the same for the Keren Hishtalmut.

I will definitely let you know what he says. Until then, there is one option left.

Method #4: Deal With It

If the money in your pension or Keren Histhtalmut is a mutual fund, it is a PFIC. According to the (temporary) regulations, you will need to report it accordingly.

This means that you need to file PFIC Form 8621 form with your tax return. Your accountant will not be happy about this. Very likely, he will express his displeasure by charging you more money to complete your return.

However, there is a bright side. After you go to the trouble of filing the PFIC form, you will find that it actually makes no difference in how much tax you owe.

Tax Calculations

As you know if you didn’t use the skipping tags, there are basically three ways that you get eaten by a PFIC when you buy a regular Israeli mutual fund in an ordinary taxable investment account. As it happens, none of these is relevant when the money is invested inside of an employees’ trust like your Keren Hishtalmut or Israeli pension.

The first way that you normally get eaten by PFIC is that the only practical way to report the income is to use the mark-to-market calculation. This calculation treats all earnings the same and taxes them at your incremental income tax rate. When this happens on an ordinary “passive” investment, it costs you money because you lose out on the lower tax that you would have paid on long term capital gains and qualified dividends.

However, any investment gain inside of an employees’ trust is anyway treated as regular income. I’m not an expert, but it seems to me that it should not matter whether you report this gain directly on your tax return or via form 8621. In either case, you should add it as other income earned in connection with your employment. It is taxed at your ordinary income rate because it is not “passive,” but that’s ok because it also means that you can apply a credit for Israeli income tax paid to cover any tax you may owe.

The second way that you normally get eaten by a PFIC is that the mark-to-market calculation forces you to realize “pretend” gains (or losses) as the exchange rate between the dollar and shekel changes. The reason for this is that you report the value of a PFIC as the change in the investment value – in dollars – between January 1 and December 31. If the same money was not in a PFIC, you would still have to report interest, dividends and capital gains in dollars, but you would do this throughout the year whenever these events occurred.

Also here, it happens to be that the same thing happens anyway in an employees’ trust, even if it wasn’t in a PFIC. When you calculate the investment gain to add to your income each year, you should be using the same dollar-based calculation.

The third reason that you normally get eaten by PFIC when you invest in an Israeli mutual fund is that you will need to pay taxes to the United States on the investment gain every year, but you only need to pay taxes to Israel when you sell your investment. This could easily cause a situation of double-taxation in which you pay taxes to the United States on your investment in one year and then pay more tax on the same money to Israel in the next year.

With money in your Keren Hishtalmut, double taxation is not a concern for the simple reason that you never pay tax to Israel on this money anyway. However, interestingly (or maybe, sadly) this could be a problem with your Israeli pension in certain cases.

What’s Next?

The conclusion is that if you hold a mutual fund inside of your Keren Hishtalmut it is a PFIC. However, the irony is that this will not make a difference on your tax bill if you treat the Keren Hishtalmut as an employees’ trust.

However, I did find in my research that there are two things that may be worth considering in managing your Keren Hishtalmut and Israeli pension.

The first is that you could avoid the problem of the PFIC (at least for your Keren Hishtalmut) by moving your Keren Hishtalmut to a self-managed account. This would allow you to buy individual stocks and bonds and avoid the PFIC entirely.

You could do this. Or, you could not do this. It really doesn’t matter that much. As long as you are treating your Keren Histalmut as an employees’ trust, there is no advantage in terms of the bottom line on your tax bill. The only reason you may want to do this is for the peace of mind of knowing that no one will ever ask you to complete form 8621.

The second thing I found is very subtle, but very important. 

There is a double-edge with the Keren Hishtalmut and the Israeli pension being employees’ trusts. On the one hand, the earnings are not “passive” and you can take a credit for Israeli income tax that you paid. On the other hand, you will pay tax at the rate of ordinary income on these investments, even if some of the gain comes from dividends and long-term capital gains.

Generally, this is not at all a concern because you should have enough credit for the Israeli income tax that you paid to more than cover any tax due. However, this would change if you reach a point where the investment gains in your Keren Hishtalmut and your pension become very large (and/or your income gets very small) to the point where you actually do not have enough credit.

If this were to ever happen to you, it would make sense for you to close your Keren Hishtalmut (and to the extent that you could, your pension) and place these investments in a regular taxable investment account instead. You could then use Investing by Accident’s Tax Equilibrium Calculator to manage these investments and pay only around 25% in taxes.

As my loyal readers know, I am a bona fide non-expert. This is why I did the only thing a non-expert could possibly do in this situation. I created a spreadsheet to calculate when it would make sense to close my Keren Hishtalmut and/or take money out of my pension. The good news is that this only happens when you are rather wealthy. The bad news is that this could reasonably be the case as you get closer to retirement.

Or, maybe that isn’t bad news. After all, it would be nice to be rather wealthy.

In any case, if you would like to see the spreadsheet, email me at donny 'at' and I’ll send it to you.


  1. I recommend what many others in Israel that are US citizens - similar to Bill Clinton's policy: "don't ask, don't tell". Then you will have no problems in life or with the IRS.