Portugal, like many other countries, has a requirement for individuals to file an annual tax return and classify their income.
It is for the taxpayer to make their best effort to classify their income correctly and the tax you owe depends on how you report it, so long as your report is uncontested by the tax authorities.
The considerable movement of many expats to Portugal in recent years has inadvertently created some complex tax questions, with some income streams being rather hard to classify.
One such complex income stream is distributions from a ROTH IRA for American taxpayers.
ROTH IRAs are US retirement saving instruments that allow taxpayers to frontload the payment of tax to a type of investment account that can then be allowed to grow tax free. The taxpayer therefore pays tax on an amount that is released to the ROTH IRA at an early stage and then benefits from ongoing capital growth within the ROTH IRA. This is opposite to most private pensions, where the contributions to the pension provide a relief from taxation when they are made, whilst tax is payable when the money is received.
Portugal does not offer any guidance on the taxation of ROTH IRA and to understand how they should be taxed requires an analysis of the Portuguese legislation.
First and foremost, it is important to understand that a ROTH IRA is a type of savings account that becomes accessible during retirement. Under Portuguese law, this is precisely the definition of pension. Pensions in Portugal are subject to a flat tax rate of 10% during the Non-Habitual Residency (NHR) year and progressive rates apply thereafter. Portugal does not offer an equivalent product to ROTH IRA and the taxation should be analysed on the basis of Portuguese law.
However, not all the income received from a ROTH IRA is pension. Article 54 of the Portuguese IRS code states that if an annuity scheme includes a portion corresponding to the reimbursement of capital, that portion is not taxable. This provision makes sense since it involves returning money to the taxpayer that was already taxed.
The Portuguese law further states that if it is not possible to identify the capital reimbursement within the total payment received, 85% of the payment is deducted as an assumed capital reimbursement. Since in most cases, the capital growth is considerably larger than 15%, it would have been lucrative for taxpayer to attempt to argue that it is not possible to identify the capital reimbursement, but in fact, it is normally possible and the correct treatment is to treat all moneys paid from the ROTH to the taxpayer as capital reimbursement as non-taxable amounts and the money paid from capital growth as pension, taxable at 10% during NHR and progressive rates afterwards.
This leads to another question – does the taxpayer have the flexibility to classify the return of capital or capital growth within the IRA as one or the other, so long as an amount lower than the total capital initially converted has been returned to the taxpayer? Our view is that the answer to this question is positive, but whether it is better for the taxpayer to treat all the initial amount as capital return or not depends on the individual circumstances of the taxpayer. For example, if the taxpayer intends to leave Portugal after the NHR period comes to an end, it would make sense for the taxpayer to classify all distributions as capital return and only start classifying distributions as capital growth once the entire initial amount has been returned.
However, if the taxpayer intends to stay in Portugal and is in risk of progressive taxation that is higher than 10%, it is better for the taxpayer to classify the earlier distributions as pension and wait until a later time to classify the remainder as capital return.
A more aggressive interpretation would be to attempt to apply the 85/15 rule despite the ability to identify the total amount of capital growth within the ROTH IRA because such application cannot be made in respect to specific payments. Such an interpretation is literally possible and could be helpful for taxpayers.
In the absence of clear instructions from the authorities, it is for taxpayers to choose a reasonable manner to report their income. Ideally, in the future clear guidelines would be provided to help individuals accurately report their ROTH IRA income and fulfill their tax obligations.
In conclusion, there are a number of ways to report ROTH IRA income in Portugal, but the guiding principle is that capital return is not taxable and capital growth is taxable as pension income.