- 1 Roth IRA is Tax-Free in the U.S.
- 2 The U.K. Honors the Tax-Free Status
- 3 What about the U.S. Tax on a 25% Lump Sum?
- 4 What is the Difference?
- 5 The Basics of the 25% Lump Sum
- 6 25% UK Tax-Free Lump-Sum Pension Payment
- 7 1. First, What is a Pension?
- 8 2. Second, How is a Pension (Generally) Taxed? 17(1)(a)
- 9 3. What if the Pension is Tax-Exempt?
- 10 4. What if it is a Lump-Sum Payment? 17(2)
- 11 Saving Clause
- 12 What does the IRS say about it?
- 13 Do you have Unreported UK Income or Account/Assets to Report?
- 14 We Specialize in IRS Offshore Disclosure
UK Tax Treatment of a Roth IRA vs. US Taxes on a UK 25% Lump Sum
UK Tax on the Roth IRA: While a Roth IRA is tax-free in the US and certain 25% Lump Sum pensions distributions are tax-free in the UK, the US UK Treaty analysis is different.
Roth IRA is Tax-Free in the U.S.
A Roth IRA is a tax-free investment vehicle.
During the contribution phase of a Roth IRA, a person contributes income that he or she already paid tax on.
And, when the retirement is distributed, the person receives the distribution tax free — since the contribution portion was already taxed.
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The U.K. Honors the Tax-Free Status
In accordance with Article 17 of the U.S. and U.K. Tax Treaty, if a Pension/Retirement is tax-free in one jurisdiction, then the other contracting state (UK) will not tax the income — since it is tax-free in the other contracting state (U.S.)
Pretty clear, right?
What about the U.S. Tax on a 25% Lump Sum?
The 25% tax- free lump sum distribution on certain UK retirement plans may escape taxability in the UK, BUT, that does not make it a tax-free pension, per se.
What is the Difference?
See, a Roth IRA is by definition a tax-free investment at distribution.
Conversely, the 25% distribution does not make the “entire” pension a tax-free pension — only the 25% withdrawal is tax-free.
In addition, while Lump-Sum payments may escape tax liability in the U.S., the treaty is not clear as to what qualifies as a “Lump Sum Payment.”
Moreover, the IRS has issued opinions in the past, and the IRS relies on the “Saving Clause” to reserve the right to tax the Lump Sum Distribution.
The Basics of the 25% Lump Sum
When a UK Person receives a 25% lump-sum payment (tax-free) as a resident of the U.S., Article 17 of the Tax Treaty becomes the main focus of the analysis. And the US /UK Tax treaty becomes even more complicated.
Each article of the Treaty has exceptions, exceptions to the exceptions, limitations, and exclusions.
Any Tax “Professional” who tells you that a treaty is “easy”..has no idea how to read a treaty. It’s proof that a little knowledge is dangerous to the general public.
One of the most common questions we receive on issues involving the UK and US treaty is how the bilateral tax treaty laws apply to the 25% lump-sum distribution of pension in the UK, which is otherwise tax-free in the UK.
Generally, the question of pensions and the UK treaty involves Article 17 of the Tax Treaty, and the Saving Clause.
We will provide you our analysis of the United States’ ability to tax the 25% UK Tax-Free-Lump Sum Pension.
25% UK Tax-Free Lump-Sum Pension Payment
As in anything legal:
- You generally analyze from general to specific; and
- There are always exceptions, exclusions, and limitations to be aware of.
1. First, What is a Pension?
Pension Defined (Article 3, Paragraph 1, Sub-paragraph (o))
The term “pension scheme” means any plan, scheme, fund, trust or other arrangement established in a Contracting State which is: (i) generally exempt from income taxation in that State; and (ii) operated principally to administer or provide pension or retirement benefits or to earn income for the benefit of one or more such arrangements.
While the term “pension” generally would include both periodic and lump-sum payments, paragraph 2 of the Article provides specific rules to deal with lump-sum payments, so they are not subject to the general rule of paragraph 1.
Plain English Definition
A pension is the type of retirement fund in which money vests either during employment or at the end of employment — and then the person is entitled to payments at retirement.
2. Second, How is a Pension (Generally) Taxed? 17(1)(a)
1) (a) Pensions and other similar remuneration beneficially owned by a resident of a Contracting State shall be taxable only in that State.
Paragraph 1 provides as a general rule in subparagraph (a), that the State of residence of the beneficial owner has the exclusive right to tax pensions and other similar remuneration.
The country you reside, is the country that taxes your pension distributions.
For example, Justin resides in the United States. He receives pension payments, which are not tax-exempt in the UK while he resides in the US.
The U.S. is country of residence and therefore has the right to tax Justin on the retirement pension income, because Justin resides in the U.S.
3. What if the Pension is Tax-Exempt?
“1(b) [T]he amount of any such pension or remuneration paid from a pension scheme established in the other Contracting State that would be exempt from taxation in that other State if the beneficial owner were a resident thereof shall be exempt from taxation in the first-mentioned State”
“However, the State of residence, under subparagraph (b), must exempt from tax any amount of such pensions or other similar remuneration that would be exempt from tax in the State in which the pension scheme is established if the recipient were a resident of that State.”
Thus, for example, a distribution from a U.S. “Roth IRA” to a U.K. resident would be exempt from tax in the United Kingdom to the same extent the distribution would be exempt from tax in the United States if it were distributed to a U.S. resident.
The same is true with respect to distributions from a traditional IRA to the extent that the distribution represents a return of nondeductible contributions.
Similarly, if the distribution were not subject to tax when it was “rolled over” into another U.S. IRA (but not, for example, to a U.K. pension scheme), then the distribution would be exempt from tax in the United Kingdom.
If a person is residing in one country (Country B) and receiving pension payments from the other country (Country A), in which the pension payments are considered tax-free or tax-exempt in that other country (Country A), the payments will be considered tax-exempt in the country of residence (Country B).
Example (US Person Residing in the UK) – Roth IRA
Maria resides in the UK but is receiving a tax-free Roth IRA.
Since the Roth IRAs are tax-free at the time of distribution in the United States, it is considered tax-free or tax-exempt to Maria as a resident in the UK.
In other words, the UK cannot tax Maria on the tax-exempt Roth IRA because had she been residing in the US — it would be considered tax-exempt.
Stated another way: the UK is not going to tax an otherwise tax-exempt United States pension even though the state of residence (UK) has the right to tax pension payments.
4. What if it is a Lump-Sum Payment? 17(2)
This is where the majority of issues originate.
17 (2): “Notwithstanding the provisions of paragraph 1 of this Article, a lump-sum payment derived from a pension scheme established in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in the first-mentioned State.”
- Lump-Sum Payment
- Pension Scheme
- Taxable only in First State
The most important part about this analysis is what is considered a “lump-sum payment.“
For example: Is a lump-sum payment the full amount of the pension or does it include partial payments? There are some definitions scattered around the IRC, Regulations, etc. — but they are less than clear.
On the one hand, it would seem that since the treaty does not state “complete disposition of the pension,” an argument can be made that the 25% lump-sum distribution is a lump-sum payment that should be covered under this portion of the treaty.
Stated differently, if the IRS meant that it only involves complete lump-sum payments, then the IRS would have emphasized “complete disposition” in the treaty.
Since the IRS does not use that phraseology, it is at a minimum at least up for interpretation.
Here are two schools of thought regarding the U.S. tax position on the lump-sum payment and summary of how the IRS has ruled on a prior occasion (not binding)
Argument 1: The 25% Lump-Sum is not taxable in the U.S.
It’s what you want to hear, right?
The Treaty does not say “complete distribution,” it says lump-sum. A lump-sum payment can be a partial payment or else it would say specifically that partial payments do not qualify.
Therefore, the argument is that the pension scheme was established in the contracting state (UK) and therefore a resident of the other contracting state (US) will only be taxed in the first mentions day (UK).
*Note: Even if this interpretation holds water, the IRS can still call in back-up (aka “Saving Clause”).
Argument 2: U.S. has the right to Tax the 25% Lump Sum Pension Distribution
Step 1 – Article 17 (1)(a)
The US has the right to tax the pension of a person who is a resident of the US unless the pension is exempt in the other country.
Since the person resides in the U.S., the U.S. has the general right to tax the pension distributions.
Step 2 The Pension is not tax exempt in the UK 17(1)(b)
Let’s assume it is a pension that is taxable in the UK, but that the UK allows you to take a 25% tax-free distribution from an otherwise taxable pension.
The entire pension is not tax exempt. Instead, the UK is carving out a 25% tax-free distribution from an otherwise taxable pension. Therefore, the pension is taxable (save for that 25% distribution).
Stated Another Way: Only the Partial Payment distribution is tax-free in UK for 25% value, but that does not make the entire Pension tax-free in the UK
Result: This is not a tax-exempt pension and therefore 17(1)(b) be does not apply.
The 25% lump sum payment is not expressly stated or defined in the Treaty.
Generally, when a person refers to “lump sum payment” they are referring to a total disposition
Example: Would you like your payment as an annuity, or in a lump-sum payment?
Therefore, the 25% lump sum payment does not qualify as a lump sum payment under 17(2).
Stated Another Way: a lump some payment presumes you are receiving the full amount of your pension payment, in a “lump sum”
Result: This is not a lump-sum payment in accordance with 17(2) and therefore, the US reserves the right to tax it.
Exceptions to the Saving Clause do not include Section 17(2), so the Saving Clause applies to 17(2).
Therefore, even if you can show that the 25% tax-free lump sum payment qualified as a lump sum payment under 17(2), the IRS can still tax you…
…and that seems to be the IRS’ general position.
What does the IRS say about it?
In 2008, the IRS issued a letter and provided the following explanation:
This letter responds to your request for information dated March 5, 2008. In your letter, you requested certain information about the tax treatment of a lump-sum distribution from a qualified U.K. pension scheme paid to a U.S. resident.
Under the Internal Revenue Code, the United States generally taxes its residents on their worldwide income, regardless of their citizenship or the source of their income. However, an income tax treaty to which the United States is a party could change the application of the law.
The United States has an income tax treaty with the United Kingdom (the Treaty). Article 17(1) of the Treaty provides that: a) Pensions and other similar remuneration beneficially owned by a resident of a Contracting State shall be taxable only in that State. b) Notwithstanding sub-paragraph a) of this paragraph, the amount of any such pension or remuneration paid from a pension scheme established in the other Contracting State that would be exempt from taxation in that other State if the beneficial owner were a resident thereof shall be exempt from taxation in the first-mentioned State.
Article 17(2) of the Treaty provides that: Notwithstanding the provisions of paragraph 1 of this Article, a lump-sum payment derived from a pension scheme established in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in the first-mentioned State. GENIN-111967-08 2
Although Article 17(2) provides that the Contracting State in which the pension scheme is established has the exclusive right to tax a lump-sum payment, Article 1(4) of the Treaty contains a “saving clause” that allows the United States to tax its residents and citizens as if the Treaty had not come into effect.
Article 1(4) of the Treaty provides that: Notwithstanding any provision of this Convention except paragraph 5 of this Article, a Contracting State may tax its residents (as determined under Article 4 (Residence)), and by reason of citizenship may tax its citizens, as if this Convention had not come into effect.
Article 1(5) of the Treaty provides a number of exceptions to the saving clause, but there is no exception for Article 17(2).
Therefore, the saving clause overrides Article 17(2) and allows the United States to tax a lump-sum payment received by a U.S. resident from a U.K. pension plan.
Do you have Unreported UK Income or Account/Assets to Report?
At Golding & Golding, we specialize exclusively in IRS Offshore Disclosure and Amnesty. We represent numerous clients from the UK each year, and we can help you.
We Specialize in IRS Offshore Disclosure
Unlike other areas of International Tax, you need a law firm that practices exclusively in the area of IRS Offshore Disclosure, and your attorney should be a Board-Certified Tax Law Specialist.
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Sean holds a Master's in Tax Law from one of the top Tax LL.M. programs in the country at the University of Denver. He has also earned the prestigious IRS Enrolled Agent credential. Mr. Golding's articles have been referenced in such publications as the Washington Post, Forbes, Nolo, and various Law Journals nationwide.
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