U.S. Taxation on U.K. Retirement & Pension
The interplay between United Kingdom (UK) income and U.S. Tax /IRS Tax Law is complex. Along with India, Australia, China, Taiwan and Hong Kong, the UK is one of the main group of countries that we represent often with international tax and offshore tax related issues.
Beyond international tax in general, when U.K./U.S. tax matters involve issues surrounding Foreign Retirement, the analysis becomes even more complicated.
Key issues we will discuss in this Article:
- FATCA Reporting Foreign Retirement or Pension
- FBAR Reporting Foreign Retirement or Pension
- PFIC Reporting Foreign Retirement or Pension
- Taxation of Retirement Contributions
- Taxation of Retirement Growth
- Taxation of Retirement Distributions
- Lump Sum
- Roll-over in the U.K.
- Roll-over into a Different Country Retirement Plan
IRS tax law for retirement involving UK and United States Income Tax and Reporting is very nebulous. There are rules, more rules, exceptions, exceptions to exceptions, and a catch-all “Savings Clause” within the U.S. – U.K. Tax Treaty which basically gives the IRS almost carte blanche right to still require U.S. tax due (even if the Treaty takes a seemingly different position).
We are providing you with as brief of breakdown as we can, while still providing enough substance so that you have an idea of how this works.
General Rule of Residence and Taxation
The general rule is that when it comes to retirement, a person’s residence is the country which has the right to tax the individual on the distributions of income (and can also require reporting on forms such as an 8938 and FBAR). Therefore, under the general rule, if a person is both a UK and US person, and/or just a US person with a UK pension and the person resides in the United States, the United States has the right to tax the individual on the income/distributions from the pension.
*Typically, there is no tax (on a U.K. Pension) until distribution, and it will continue to grow tax-free – although the rule changes when a roll-over is involved.
Reporting a U.K. Pension or Retirement
Compared to the laws surrounding distribution of pension or retirement funds, the laws regarding the reporting of your UK pension is less complicated and relatively simple: the general rule is that you have to report it.
More specifically, you report your Foreign Pension on a variety of different forms (facts and circumstances depending) such as a
Private Pension or Retirement
In almost all circumstances, a US person who has a UK pension is required to report the pension or retirement on a FBAR and possibly FATCA Form 8938 (presuming at least the +$10,000 threshold is met). That is because, the pension or foreign retirement has its own account number, and therefore would be included on the reporting.
Public Pension or Retirement
The distinction of whether the pension would have to be reported is not dispositive based on whether it is a public or private pension or retirement fund. Rather, the distinction lies in the fact that if it is a public pension or retirement, the chances are it may not have its own account number.
For example, if a person earned a public pension while working for the UK government or university, then the person may have a defined benefit amount upon maturity, but the defined benefit may not have a lump-sum or surrender value.
In other words, the person may not have the ability to take a lump sum value from a public pension. Therefore, since there is no individual account number or surrender value/maturity value beyond the defined-benefit the person may receive monthly, it may be difficult to report.
*Whether the Foreign Financial Institution (FFI) is exempt from reporting (as is common in various different versions of IGAs) has no direct bearing on whether and individual is exempt from reporting as well.
Unfortunately, this is a term that is thrown around loosely by tax professionals who have no idea what it means. A PFIC is a Passive Foreign Investment Company. Not every foreign retirement plan will be considered a PFIC. In fact, the majority of them will not be a PFIC.
But, if it is a private pension plan in which there were no employer contributions and/or if the employee has contributed more to the plan than the employer (+50%), then the plan may now closely mimic a grantor trust as opposed to an employment trust. As a result, there may be more complex issues at play and the retirement may be more of a private investment fund a.k.a. PFIC.
We recommend speaking with an experienced offshore tax lawyer first before making any affirmative representations to the IRS re: PFIC Reporting, such as filing an 8621.
Income Growth and Deferment of Salary
Deferment of Salary into the Retirement Fund
When a person has a 401(k) or other similar type of retirement plan in the United States, typically the employer and employee can contribute tax-free to the retirement plan. For example, if David’s employer contributed $10,000 of David’s salary (pretax) to a retirement plan such as a 401(k), David is not taxed on that $10,000 now.
Rather, David is taxed in the future when the money is distributed, with the understanding that hopefully at retirement, David’s tax bracket will be lower than it is during his work years and therefore he is receiving a benefit. Likewise, a portion of David’s contribution of his own salary is usually also tax-deductible.
The same cannot be said of foreign retirement plans and U.S. Tax Law. For example, if it is a private pension in the UK and salary is being deferred into that retirement plan, unless it meets certain qualifications, that income is immediately taxable to the employee on his or her U.S. Tax Return. The same goes for the contribution made by the employee to the fund.
As we mentioned before, the US and UK tax treaty is very comprehensive when it involves foreign retirement, and each particular type of investment must be reviewed carefully to determine tax liability.
Income Growth Within the Retirement Fund
Whether or not the income growth within the pension would be taxed is based on many different factors, but typically between the United States and the UK, the growth within the fund is not taxed, but not always.
Oftentimes, the growth within the specific Pension type will not be taxed until it is distributed. For the record, we are talking about U.K. Retirement and not for example a roll-over from a U.K. pension into a QROPS/ROPS, which may qualify for U.K. deferred treatment, but probably not under U.S. Law.
There are many different factors that should also be considered in reviewing income growth within the retirement fund:
– The country of residence of the individual
– Whether money is still being deferred into the pension
– Where the person resided when the pension was funded
– Has all the income that was deferred into the pension been properly taxed by the US (if applicable U.S. Status)
– Has the pension been rolled over
– Have there been any distributions from the pension either monthly or lump sum (even if the lump sum is distributed monthly)
The laws regarding pension distributions earned by individuals residing in the United Kingdom and who are now either living in the United States or otherwise considered a US person are very complex. Typically, the main issue will be what the status was of the individual when he or she was earning pension, and, whether that pension was taxable at the time the income was being earned – in addition to the current resident status of the individual when or he is receiving the pension and whether payments are received lump sum or periodically.
The US & UK treaty has multiple exemptions and exceptions. One of the most common is the fact that if the pension or other retirement fund is exempt from tax where the pension scheme was established, then there would be no tax imputed within the country of residence.
Therefore, if the pension was established in the UK, then the general rule (exceptions, and exceptions to exceptions will apply) is that the earnings from the pension will not be taxed by the country in which the person resides.
We will discuss this further below.
Main Exception to the Exception
The exception listed above does not apply when the person receives a lump sum benefit from the pension, even if it would otherwise be tax.
Rule: There is no definitive rule on the subject. But, in 2008 there was a memo issued by the IRS, which (succinctly) summarized the rule for a U.K. person, who is also subject to U.S. Tax and residing in the United States.
– First, Generally it will be the state of residence that taxes the pension distributions. Therefore, if a person is a resident of the United States, in the United States will tax the pension distribution.
– Second, if the distribution would otherwise be tax-free in the state in which the pension was earned (UK), then it would also be tax free in the state in which the person resides (United States).
– Third, when it involves a lump sum payment, it is the first contracting State (The UK in our example because that is where it was earned) who can Tax the lump sum distribution, even if they choose not to.
– Fourth, despite everything you read above, the savings clause allows the United States to basically toss away these rules and tax the lump sum distribution of the US resident anyway, unless there is a restriction somewhere else in the treaty.
**Even though there are several exceptions to the savings clause (a.k.a. exceptions which prohibit the United States from disregarding the treaty and relying on savings clause), this is not one of them.
Result: the IRS could feasibly still tax a US resident on an otherwise tax-free lump sum distribution from a UK pension, which are otherwise be tax-free in the UK (even though the treaty reserves the right to allow the UK to tax that lump sum distribution)
*This summary was based on an internal memo from the IRS back in 2008. The laws do change but the purpose is to give you an idea of how the IRS brain works.
Presumption: While there is no definitive rule on how the IRS would tax a periodic payment of the lump sum payment, but presumably the IRS would still try to tax it.
25% distribution Tax-Free
Depending on the type of retirement the person has in the United Kingdom, there is a rule which allows a person to take it one time 25% lump sum distribution from their pension without being taxed. Typically, this retirement distribution would still be taxed under US law, but certain restrictions do apply.
U.S. Resident Receiving Lump Sum
If the person receiving the Lump Sum payment resides in the U.S., the United States may still tax the pension lump sum distribution under the savings clause of the UK and US tax treaty. Moreover, the treaty does reserve the right to allow UK to tax the pension as well.
See above for more details.
If the pension is rolled over into another pension between countries (for example rolling over a pension to the U.S. or a QROPS/ROPS), the United States might see that as a distribution, which is immediately taxable (Read: The United States will see it as a distribution, and you will be taxed).
There are many reasons for this, but one of the primary reason is because during the growth of the fund, chances are contributions were being made from the employee and were tax-free in the UK. Moreover, chances are that the person did not report the deferred income on his or her US tax return (a person does not get the same deferred treatment for a non-approved foreign retirement plan, as they would for 401(k), even if the deferred salary is directed to a qualifying foreign Retirement plan).
Taking a Lump Sum as Installments
A common issue we have seen lately with many of our clients, is the issue of whether a person can take the 25% lump sum distribution in annual installments in order to avoid immediate taxation. In other words, there is a distinction to be made as to whether a person takes a lump sum distribution, or monthly/annual distribution when it comes to U.S. taxation rules on a U.K. retirement. The United States tax rules are more lax when it comes to installment distributions versus a one-time lump sum distribution.
The question becomes, whether a person can sidestep the lump sum taxation by the United States for the 25% distribution on a lump sum payment from a UK pension by taking the lump-sum distributions as annual installments.
That is because, unlike a lump sum payment, periodic distributions which are not taxable and the UK are also not taxable in the US (subject to any savings clause argument the IRS may make).
*There is no definitive rule on the subject, but more likely than not the IRS would try to tax it as a Lump Sum (Read: Why woudn’t they?)
Rollover into a QROPS/ROPS
A QROPS/ROPS is a recognised overseas pension plan, and a common question is that when a UK pension is contributed/rolled-over into a QROPS/ROPS, whether is taxable by the IRS.
The QROPS/ROPS is is a Maltese (primarily), Isle of Mann, New Zealand or Gibraltar based retirement plan. There are very specific rules under the UK laws, which allow a person to transfer or rollover their UK retirement into aQROPS/ROPS.
There are some benefits to transferring the UK retirement into a QROPS/ROPS, which typically include a higher lump sum payout, tax-deferred growth, possibly reduced income tax on the distributions depending on the tax treaty between the other country and the UK (if the state or country of residence taxes the retirement). In addition, there may also be a reduction and estate tax, as well as and earlier age in which the person can take distribution.
U.S. Taxation of a QROPS/ROPS
Presumably this type of retirement would be taxed (including growth) despite any treaty between the U.S. and U.K.
Why? Essentially, there is no reason why it could avoid taxation. First, a QROPS/ROPS is not an approved by the IRS for US tax retirement. Second, by rolling it over or contributing it to the ROPS, the person has essentially taken a lump sum distribution in the eyes of the IRS, which is taxable.
Rollover into a U.S. Fund
Rolling over UK retirement into a US-based retirement is presumably going to be taxed by the IRS. In a memo issued back in 2009, the IRS summarized these issues as follows:
Issue 1: The Language of the Treaty:
Paragraph 1 of Article 18 (Pension Schemes) provides that: Where an individual who is a resident of a Contracting State is a member or beneficiary of, or participant in, a pension scheme established in the other Contracting State, income earned by the pension scheme may be taxed as income of that individual only when, and, subject to paragraphs 1 and 2 of Article 17 (Pensions, Social Security, Annuities, Alimony, and Child Support) of this Convention, to the extent that, it is paid to, or for the benefit of, that individual from the pension scheme (and not transferred to another pension scheme).
General Rule: growth within the retirement fund will not be taxed. Rather, it is not until the income distributed that the individual will be taxed by the state of residence.
Issue 2: And Not Transferred to Another Pension
The question becomes whether the verbiage (and not transferred to another pension scheme) means that a rollover is not taxable. The IRS summarizes its position by stating that if the rollover is a proper rollover (for example a UK rollover into her UK fund or US rollover into a US fund) then this would not be considered a distribution of income.
But, if it is rolled over into a U.S. Retirement Account, the IRS will tax the roll-over.
Specifically, the IRS provided ”the transfer is not an “eligible rollover distribution” within the meaning of section 402(c)(4), Article 18(1) would not be applicable and the transfer of income earned by the U.K. scheme (together with pre-tax contributions to the U.K. scheme) may be treated as a taxable distribution in the United States.
Note that although Article 17(2) of the Treaty provides that lump-sum distributions derived from a pension scheme established in one country and beneficially owned by a resident of the other country are taxable only in the country where the pension scheme is established, the so-called “saving clause” in paragraph 4 of Article 1 (General Scope) generally allows each country to tax its residents (as determined under Article 4 of the PRENO-136253-08 4 Treaty) as if the Treaty had not come into effect. Thus, the saving clause would permit the United States to tax a lump-sum distribution to a U.S. resident from a U.K. scheme.”
The IRS protects position by reiterating that under the savings clause, unless an exception savings clause applies, the US can still tax the rollover for a UK retirement into a US retirement.
IRS Compliance – What Happens if I do not Report?
Here’s the deal: there is no way to know whether you will be one of the unlucky ones the IRS audits. The IRS is understaffed and underfunded – which is a double edged sword.
On the one hand, the chances of being audited are relatively slim – although this does increase based on factors such as foreign income, foreign accounts and highly compensated earners, but overall many people will go their whole life without ever being audited.
On the flip-side, if you are audited, it can become a very arduous process and very difficult to negotiate with the IRS when they are only operating at 20 or 30% capacity. In other words, trying to get somebody on the phone could take hours upon hours of your time. The IRS is a major bureaucracy, and trying to make your way through the different levels is very difficult.
Compounded by this time issue, is the fact that the IRS has the right to issue various means of recovery against you (against both your US and foreign property, income, accounts, etc.), such as:
IRS Offshore Voluntary Disclosure
Before making any affirmative representation, or past filing to the IRS it is important to speak with an experienced offshore disclosure where to learn the pros and cons of each different approach.