Pensions

A dual UK/US citizen, I've lived in the UK for the past 30 odd years and will be entering retirement soon, staying in the UK.  (I file both UK and US annual tax returns and FBAR.)

I have several UK personal pension plans with established providers (e.g. Scottish Widows, Avivia, Legal & General).  From a UK perspective, when I retire each plan allows me to take up to 25% of the value tax free and the rest is treated as taxable income.  But from a US perspective, how will the IRS consider my receipt of these 25% lump sums?  Are they taxable or not taxable from a US perspective?

I wish you good fortune in finding an answer to this situation. Although the OP is in an entirely different situation to yours, have a look at this very recent thread from another site.

http://britishexpats.com/forum/usa-57/uk-pensions-related-uk-us-tax-treaty-894492/

May I enquire, please, for US tax purposes, did you declare the UK income used to pay for the UK pensions as taxable income on your US tax returns (1040s)? For the UK, were the funds paid into the pensions declared on your UK tax returns (or PAYE) as UK taxable income pre-investment, or were they tax free in the UK at the time of investment?

Internal Memo to nun:
Basis, now?

It's all about that bas...is

It would be great if the OP has a large US tax free basis already, but I imagine this thread will quickly become a discussion on the definition of "lump sum". My opinion is that when taking a UK tax free pension amount it is prudent for US tax purposes to take it as a series of periodic payments so that Article 17.1 can be applied without argument.

It's all about that bas...is

..... but I imagine this thread will quickly become a discussion on the definition of "lump sum".

Before we come to that point, IMHO, the issues are separate. The question of the 25% lump sum amount, and the answer, is an independent issue. The only question is the future returns of a US person who has contributed to a UK pension while resident in the UK, and has declared the part of their income used for the contributions (or possibly employers contributions as well), for US tax purposes on a 1040, as taxable income for US purposes. Do they therefore have a basis in the pension which will, if the UK 25% tax free amount is claimed as tax free for US purposes, require additional calculations to pro-rate the tax free 25% portion from the remaining 75% taxable portion in order to come to a correct basis for future declarations of UK pension income on the US return? Assume they use the 'general method' to develop the basis.

In which case, could a better(?) option be to not declare as income (via the treaty?), for US purposes, either their UK contributions, the UK employers contributions, and any growth, which would result in 0% basis in the pension, but still allow them (if the 25% lump sum is allowed) to take that 25% tax free and only declare for US purposes the remaining 75% as taxable income?

It's likely all moot due to the higher tax rates in the UK, or the use of, perhaps for the taxpayer, an over generous FEIE in the contributory stage prior to the pension becoming active. Nonetheless, how to handle future US returns may require some serious considerations.

And, what if the taxpayer already has a large, or full, basis in the pension for US purposes? The 25% tax free helps for UK purposes, but not so much for US purposes since they now have UK income, or a portion, which is twice tax free. But, in the overall picture does that matter? Their main gain is the 25% in the  UK.

The joy having to declare to two distinctly independent, and completely different, tax regimes and rules (and the joy of the retired individual with a vacant brain and nothing better to do than come up with these preposterous thoughts).

For example, if there's a 50% tax free US basis and the UK 25% tax free amount is taken as periodic pension income payments does that produce a 75% US tax free basis???

It's all about that bas...is

 

Or, is 50% of the remaining 75% tax free, and you lose the 50% basis tax free on the 25% tax free lump sum?

Or, is the total amount of tax free basis amount (@50% of the original pension amount) applied to the remaining 75%, and the 25% tax free lump sum is a separate tax free amount? (a different way of stating your example, but with a lump sum, not periodic)

It appears to be a unique situation for the USC who has been resident in the UK whilst contributing to a UK pension.
 
For a USC resident in the US, contributing to a US pension (IRA/40xx), it's tax free going in (if I understand correctly) and taxed on the way out.

It's the same for a UKC resident in the UK, contributing to a UK pension (up to a limit),  it's tax free going in and taxed on the way out. The 25% tax free lump sum means only paying tax on the remaining 75%.

The UK allows a ROTH to be tax free; tax free going into an IRA and taxed when converted to a ROTH, but tax free going out (again, if I understand the US system correctly). But, US tax is paid at one point.
 

The UK allows a ROTH to be tax free; tax free going into an IRA and taxed when converted to a ROTH, but tax free going out (again, if I understand the US system correctly). But, US tax is paid at one point.

You can also fund a Roth with after-tax contributions just like an ISA, and that is probably the way most Americans contribute as it is more flexible when it comes to withdrawals. (The contributions can be withdrawn without penalty after 5 years is one advantage).

Or, is 50% of the remaining 75% tax free, and you lose the 50% basis tax free on the 25% tax free lump sum?

Or, is the total amount of tax free basis amount (@50% of the original pension amount) applied to the remaining 75%, and the 25% tax free lump sum is a separate tax free amount? (a different way of stating your example, but with a lump sum, not periodic)

Well a tax free basis built up using FTCs will be a dollar amount...those dollars have already had US tax paid on them. However, the UK tax free amount is oblivious to the US tax basis and I don't think you'd get to choose the pounds to apply the 25% tax free amount to. So if you have a £100k UK pension pot and a £50k tax free US basis it seems sensible that the 25% UK tax free amount would be equally divided between the US taxable and tax free amounts so in practice you'd get a 12.5% extra US tax free amount.....if the withdrawals are taken as periodic income.

Well a tax free basis built up using FTCs will be a dollar amount...those dollars have already had US tax paid on them. However, the UK tax free amount is oblivious to the US tax basis and I don't think you'd get to choose the pounds to apply the 25% tax free amount to. So if you have a £100k UK pension pot and a £50k tax free US basis it seems sensible that the 25% UK tax free amount would be equally divided between the US taxable and tax free amounts so in practice you'd get a 12.5% extra US tax free amount.....if the withdrawals are taken as periodic income.

First, my apologies to Alan, the OP of this thread. We've not directly answered your question. The link to BritshExpats (and a thread from earlier this week) in the second post on this thread covers all the answers, or more precisely, all the confusion, surrounding the issue. It's likely already more complete than a discussion we will have here. Three items to note: 1) the tax professionals opinion (it's not taxable); 2) reference to the IRS letter of past (a UK 25% lump sum is taxable); and 3) further clarification is needed. The summation seems to be until a further ruling is issued, thanks to the change in HMRC rules, if the 25% lump sum were to be taken as tax free in the US the taxpayer should have written confirmation of the stance from a tax attorney and a form 8833 must be filed claiming the treaty stance.

Other interpretations are welcome.

As for your thoughts, nun, I agree. Some amount of apportioning would seem prudent. My guess would be the 939 (general rule) publication would be completed first, and apportionment would follow. One thing seems to be for sure: there will be no IRS guidance available on how to apportion in this instance. If I were doing this now, I would tend to be on the side that taking a lump sum, all at one time, is a taxable event.

For reference: I did not take the 25% lump sum but took a full UK pension instead. But, that was 10 years ago and the agreed stance at that time was it was not US tax free.

 

I see my OP has reopened an old can of worms. Sorry.

I've gone up a steep learning curve in the past 24 hours, reading the UK/USA Double Taxation Convention (DTC) https://www.gov.uk/government/publications/usa-tax-treaties, the Treasury's technical explanation https://www.treasury.gov/resource-center/tax-policy/treaties/Documents/teus-uk.pdf, various forum threads and other online sources, one of which seems to describe my situation and the 25% lump sum perfectly. https://www.taxation.co.uk/Articles/2015/04/28/332979/us-taxing-rights.

May I enquire, please, for US tax purposes, did you declare the UK income used to pay for the UK pensions as taxable income on your US tax returns (1040s)? For the UK, were the funds paid into the pensions declared on your UK tax returns (or PAYE) as UK taxable income pre-investment, or were they tax free in the UK at the time of investment?

Not sure I understand the query.  Are you trying to lead me down another rabbit hole? 
For US tax purposes I simply declared my gross UK income (salary, interest, dividends) as taxable income on my 1040s.  Between the Foreign Earned Income exclusion (Form 2555) and standard deductions/exemptions, my taxable income was never high enough to pay any US tax.  For the UK, to make a pension contribution, e.g. I would write a check to L&G for £800 which got grossed-up to £1,000; I then declared the pension contribution on my SA100s filed with the HMRC.

It's all about that bas...is

It took me awhile, but I got it. Clever.   

It would be great if the OP has a large US tax free basis already, [...]

I also have recently inherited IRAs (traditional and Roth) and variable annuities in the US.  Reading the DTC has helped clarify matters to an extent.

The joy having to declare to two distinctly independent, and completely different, tax regimes and rules (and the joy of the retired individual with a vacant brain and nothing better to do than come up with these preposterous thoughts).

I'm still learning and trying to fill my vacant brain too. 

This may be a dumb question, people's views of the DTC has me puzzled.  It was clearly put together to address US/UK taxation issues and Article 17 seems to address the issues with pensions.  It's the saving clause, Article 1(4), that seems to drive everyone mad because Contracting States reserve their rights to tax their residents and citizens as if the DTC didn't exist (except for Articles 17(1)(b), 3 and 5.)  But isn't the saving clause simply a "get out clause" for the tax authorities (IRS or HMRC) to draw upon in those (hopefully rare) instances where they need to prevent some clever clogs from evading tax that ought to be paid, or to cover unforeseen cases not adequately covered by the DTC?  In other words, isn't the saving clause a trump card to be played only in exceptional circumstances?  Or am I being incredibly naive and in reality the IRS regularly uses the saving clause to get its own way to raise revenue for the Fed despite the terms of the DTC including Article 17?

I'm still making my way through the BritishExpats thread.

For reference: I did not take the 25% lump sum but took a full UK pension instead. But, that was 10 years ago and the agreed stance at that time was it was not US tax free.

.....but I assume you are only paying US (and UK) tax on 75% of your pension because that definitely qualifies as income

I see my OP has reopened an old can of worms. Sorry.

That's a 'perpetual' can of worms.

Not sure I understand the query.  Are you trying to lead me down another rabbit hole?

No rabbit holes, just trying to determine if you have a basis in the pension for US purposes.

This may be a dumb question, people's views of the DTC has me puzzled.  It was clearly put together to address US/UK taxation issues and Article 17 seems to address the issues with pensions.  It's the saving clause, Article 1(4), that seems to drive everyone mad because Contracting States reserve their rights to tax their residents and citizens as if the DTC didn't exist (except for Articles 17(1)(b), 3 and 5.)  But isn't the saving clause simply a "get out clause" for the tax authorities (IRS or HMRC) to draw upon in those (hopefully rare) instances where they need to prevent some clever clogs from evading tax that ought to be paid, or to cover unforeseen cases not adequately covered by the DTC?  In other words, isn't the saving clause a trump card to be played only in exceptional circumstances?  Or am I being incredibly naive and in reality the IRS regularly uses the saving clause to get its own way to raise revenue for the Fed despite the terms of the DTC including Article 17?

The stumbling block is the definition of a lump sum as it pertains to the US/UK Treaty. To quote Cook_County in the BE thread "Under US domestic law an LSD is a complete distribution. Anything else is arguably periodic." Note the use of arguably. The question is does the US definition apply to the definition for use in the tax treaty? You can find answers for both alternatives (taxable, not taxable) depending on which expert you consult.

The US can determine whichever definition it chooses for the taxation of USCs, and whether the saving clause applies or not. 

.....but I assume you are only paying US (and UK) tax on 75% of your pension because that definitely qualifies as income

For the UK, my tax coding confirms HMRC see the entire pension as taxable (obviously, allowing for a personal allowance). I chose not to have the 25% tax free option, an unheard of action for 99.9% of those taking a UK pension. Thank you, America.

For the US, I've established my basis (declared on past returns as income for US purposes) in the pension and declare the remainder. The basis is under 25% if I remember correctly.