digest
Short Summary
Main recommendation: Israeli-resident Americans and Olim holding PFICs (Passive Foreign Investment Companies, such as foreign mutual funds or foreign ETFs) should avoid them and instead hold individual securities, such as outright bonds and stocks, because PFIC taxation is punitive. Ron Zalben also explains that during Israel's 10-year tax exemption, foreign-source income is generally exempt in Israel, while the U.S. treaty generally prevents double taxation by giving one country the "first bite" and the other a credit.
Key Points
- A PFIC is a Passive Foreign Investment Company; the typical example is a foreign mutual fund, and U.S. legislation from 1986 made these harder to hold. The rule applies worldwide, not only to Israelis.
- PFIC taxation can reach ordinary rates up to 37 percent, and with the interest charge the speaker has seen it reach 60 percent.
- Israel's 10-year tax holiday exempts foreign-based interest, dividends, capital gains, rental income, royalties, and work income earned abroad.
- The treaty decides who gets the first right to tax income; for example, U.S. interest and dividends are first taxed by the U.S., and Israel gives a credit.
- Social Security is tax-free in both the U.S. and Israel under the treaty, and U.S. federal, state, or local pensions are exempt in Israel after the 10 years while remaining taxable in the U.S.
Details Worth Noting
- Concrete instructions:
- Before investing locally in Israel, avoid foreign mutual funds and ETFs (PFICs) and buy individual securities instead, which are treated as regular investments.
- To track the market without a PFIC, pick the 15 or 20 largest Israeli companies by market cap and invest equal amounts in each.
- Before claiming Social Security while still working in your mid-60s, check the earnings threshold at ssa.gov, since the rules for those living abroad differ, and consider waiting until full retirement age (generally 66 or 67, depending on birth year).
- When people show their local investments, they're told to speak to their accountant because they may be in trouble (PFIC issues); Israeli bank advisors often recommend these mutual funds and many don't understand PFIC rules.
- Note that municipal bond interest is tax-free in the U.S. but taxable at 25 percent in Israel.
- The PFIC interest-charge method spreads the gain over the holding period, applying interest to each year's portion, so long holds can produce very high combined taxes.
- The QEF election is generally unavailable for Israeli mutual funds because the required annual income information is usually not provided.
- Social Security benefits remain tax-free in Israel even after the 10-year exemption ends.
- Full retirement age is determined by the U.S. Social Security Administration and depends on birth year (generally around 66 or 67).
Bottom Line
Israeli-resident Americans should treat PFIC-holding local funds as a tax trap and check treaty and exemption rules before making investment or retirement income decisions.
