UK Tax treatment of IRA distributions

My wife and I each have Traditional IRA’s in the US from when we lived there. We expatriated from the US back to the UK many years ago and are UK citizens and tax payers.

We each plan to take full distributions this year from the IRA’s and close the accounts. Vanguard will withhold 30% and we will each file 1040NR’s to hopefully recover that. When I questioned HMRC about how the withdrawal is treated in the UK I received the following response: ‘A traditional IRA, is not recognised in the UK as a pension schemee, but as a savings account and monies taken from the IRA is treated as interest arising from a savings account.’ Furthermore HMRC tax the gross amount, not the net amount after the 30% withholding.

I have been reading that Roth IRA’s are treated differently tax-wise in the UK (tax-free) and wonder if it would be worthwhile to transfer our Traditional IRA’s to Roths? But I also believe there is a 5 year rule about withdrawing from Roth IRA’s.

I would appreciate any advice. Thanks.

The 30% withholding is not the final tax. Contributions are taxed at graduated rates, growth at 30%. There should be a smidgeon of a refund when the US return is filed. The lump sum is fully taxed by the UK, with a credit for the final US tax - whatever that turns out to be once the US returns are prepared.

Have you received HMRCs response in a letter addressed to you personally?

Thank you for your response. Yes I was aware that contributions are taxed differently in contrast to growth. However I do not believe I am entitled to a credit.

The following is the full response I received from HMRC when I contacted them personally on how IRA distributions were treated by HMRC.

‘A traditional IRA, is not recognised in the UK as a pension schemee, but as a savings account and monies taken from the IRA is treated as interest arising from a savings account. 
 The traditional IRA is taxable in the USA, since payments into the account receive tax relief given to the individual by the employer. 
 This means that money taken out of the IRA, whether as regular payments or as a lump sum, is taxable in the UK and is reported as overseas interest in the foreign section of the tax return, when you are resident in the UK. 
 In the foreign section of the self assessment tax return SA106, you declare the income from the IRA.  There is no US taxation if the pension is subject and liable to UK tax.
 If US tax is withheld, then the individual, should seek a refund of this tax (file a form 1040NR).  HMRC will not give a credit for this tax against any UK tax charged on this income. ‘

Thanks - this is very helpful. You may wish to write further letters to HMRC to state that you disagree. A few observations.
1. Under UK domestic law, an IRA is not a UK registered pension plan.
2. The UK-US tax treaty modifies UK domestic law. Article 17(1)(a) will include an IRA distribution as pension income.
3. The US retains the right under the domestic laws of the United States to charge tax.
4. The UK gives a credit for the actual US tax due.

I also disagree with the HMRC statement in the letter where it says

“ The traditional IRA is taxable in the USA, since payments into the account receive tax relief given to the individual by the employer. ”

An IRA is not associated with a particular employer, one just needs to have earned income to contribute to an IRA - the I stands for Individual. If you were lucky enough to exceed the income limits for tax deduction as I was for quite a few years you could make non-deductible contributions using after tax money such that on withdrawals the return of principal is not taxed, just the gains. Section 17 also covers that so the UK should not tax the return of  after-tax contributions, which are listed in the 1099-R tax forms issued by the IRS when withdrawals are made.

Here is the text which I extracted from the tax treaties for discussions with my tax advisors.
Please note that you need to discuss with your financial adviosrs as to their interpretation of this information along with the resulting impact on any taxes owed in either juristisdiction.

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Extracted information from tax treaty document available on webpage:
Tax treaties and related documents between the UK and USA.
https://www.gov.uk/government/publications/usa-tax-treaties


Under Article 3 General Definitions:
Paragraph 1, sub-paragraph (o)
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.

Article 17 describes treatment of lump-sum payment from a pension scheme:

ARTICLE 17  Pensions, social security, annuities, alimony, and child support
1.(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.
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.

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To clarify which “State” is which, my reading of this reads as:
A lump-sum payment derived from a pension scheme established in the US and beneficially owned by a resident of the UK shall be taxable only in the US.
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Under “Exchange of Notes” is clarification as to “pension scheme” definition.
With reference to sub-paragraph (o) of paragraph 1 of Article 3 (General Definitions):

it is understood that pension schemes shall include the following and any identical or
substantially similar schemes which are established pursuant to legislation introduced
after the date of signature of the Convention:

(a) under the law of the United Kingdom, employment-related arrangements
(other than a social security scheme) approved as retirement benefit schemes
for the purposes of Chapter I of Part XIV of the Income and Corporation
Taxes Act 1988, and personal pension schemes approved under Chapter IV of
Part XIV of that Act; and

(b) under the law of the United States, qualified plans under section 401(a) of
the Internal Revenue Code, individual retirement plans (including individual
retirement plans that are part of a simplified employee pension plan that
satisfies section 408(k), individual retirement accounts, individual retirement
annuities, section 408(p) accounts, and Roth IRAs under section 408A),
section 403(a) qualified annuity plans, and section 403(b) plans.

7springs thank you for your detailed response.  However I have been doing further investigating and have determined the following.

Article 17(2) of the UK/USA of the double taxation agreement provides the US with the right to tax any Lump Sum payment which is made from a US sourced pension scheme (including IRAs).

However, the UK is also permitted to tax the same lump sum payment, which is in accordance with Article 1(4) of the agreement.   
                                                                                                                                                           
Article 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 (USA) and beneficially owned by a resident of the other Contracting State (UK) shall be taxable only in the first-mentioned State (USA).

Article 1(4) - Notwithstanding any provision of this Convention except paragraph 5 of this Article, a Contracting State (UK and/or USA) may tax its residents, and by reason of citizenship may tax its citizens, as if this Convention had not come into effect.

As a UK resident, Article 1(4) effectively ‘overrides’ the provision at Article 17(2), and the consequence is that both the UK and USA can tax any Lump Sum payment received from a US sourced pension scheme.
 
In these situations, double taxation will occur since both the UK and the USA can tax the same income. However, that double taxation will be eliminated in accordance with Article 24(4)(a) of the double taxation agreement which requires the UK (as the country of residence) to provide a credit to offset the US tax correctly paid against the UK tax charged on the same the IRA withdrawal. 

7springs thank you for your detailed response.  However I have been doing further investigating and have determined the following.

Article 17(2) of the UK/USA of the double taxation agreement provides the US with the right to tax any Lump Sum payment which is made from a US sourced pension scheme (including IRAs).


However, the UK is also permitted to tax the same lump sum payment, which is in accordance with Article 1(4) of the agreement.   
                                                                                                                                                           
Article 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 (USA) and beneficially owned by a resident of the other Contracting State (UK) shall be taxable only in the first-mentioned State (USA).

Article 1(4) - Notwithstanding any provision of this Convention except paragraph 5 of this Article, a Contracting State (UK and/or USA) may tax its residents, and by reason of citizenship may tax its citizens, as if this Convention had not come into effect.

As a UK resident, Article 1(4) effectively ‘overrides’ the provision at Article 17(2), and the consequence is that both the UK and USA can tax any Lump Sum payment received from a US sourced pension scheme.
 
In these situations, double taxation will occur since both the UK and the USA can tax the same income. However, that double taxation will be eliminated in accordance with Article 24(4)(a) of the double taxation agreement which requires the UK (as the country of residence) to provide a credit to offset the US tax correctly paid against the UK tax charged on the same the IRA withdrawal. 

I concur - but with just one proviso which is that the US tax withheld - if any - is not the final US tax. You'll need to file a Form 1040-NR to calculate the amount of US tax payable on the contributions to the plan so that the correct amount of US tax is claimed as a credit in the UK.

“ You'll need to file a Form 1040-NR to calculate the amount of US tax payable on the contributions to the plan so that the correct amount of US tax is claimed as a credit in the UK.”

Agreed. The useful aspect of this is that the 1040NR will be filed and hopefully finalised before the need to file the UK tax return.

I concur - but with just one proviso which is that the US tax withheld - if any - is not the final US tax. You'll need to file a Form 1040-NR to calculate the amount of US tax payable on the contributions to the plan so that the correct amount of US tax is claimed as a credit in the UK.

Out of curiosity, what would you do if you hadn't kept records of all your contributions to your 401(k) and it had long since been rolled over into an IRA.  I imagine there are many people in this position, who worked in the US for some years a long time ago.  They may even have moved the IRA/401(k) to a different provider.  Where would the records be held?  Possibly only on the person's US tax returns?  And they may not still have those records.  What would one do in this case?  Asking for a friend.

I'm not an expert on this, but I would assume that the entity that managed your 401K might still possibly have records. It probably would depend on how long ago it was, though, as to if they've kept them.  For example, if Fidelity managed your 401k through your employer, that's where I'd go first.

You can also request tax transcripts from the IRS. See https://www.irs.gov/individuals/get-transcript  I think you can only get the prior 3 years', though. But it might be worth reading through their website page to see if there's some other report there that might be of use to you.

Out of curiosity, what would you do if you hadn't kept records of all your contributions to your 401(k) and it had long since been rolled over into an IRA.  I imagine there are many people in this position, who worked in the US for some years a long time ago.  They may even have moved the IRA/401(k) to a different provider.  Where would the records be held?  Possibly only on the person's US tax returns?  And they may not still have those records.  What would one do in this case?  Asking for a friend.

Each year I made non-deductible contributions to my IRA I filed form 8606 with my IRS return and it is that record that informs the IRS. Line 14 on the 8606 shows "your total basis in traditional IRAs for [this year] and earlier years" and this figure is carried forward to the next tax year to be added to that year's cost basis, as per lines 1-3 on the form 8606.

For my 401k contributions they were all 100% before tax contributions and I don't think my employer was unusual in that they didn't allow after-tax contributions. The same goes with my wife's company 401k and when we rolled over our 401ks to IRAs they went into Rollover IRAs so we knew that none of that money held any after tax contributions, that is to say those IRAs were 100% taxable.

Your friend would need a copy of his last 401k statement which would show how much, if any, was after-tax contributions, the IRS would not know because, unlike the IRA contributions, they are not reported to the IRS.

Each year I made non-deductible contributions to my IRA I filed form 8606 with my IRS return and it is that record that informs the IRS. Line 14 on the 8606 shows "your total basis in traditional IRAs for [this year] and earlier years" and this figure is carried forward to the next tax year to be added to that year's cost basis, as per lines 1-3 on the form 8606.

For my 401k contributions they were all 100% before tax contributions and I don't think my employer was unusual in that they didn't allow after-tax contributions. The same goes with my wife's company 401k and when we rolled over our 401ks to IRAs they went into Rollover IRAs so we knew that none of that money held any after tax contributions, that is to say those IRAs were 100% taxable.

Your friend would need a copy of his last 401k statement which would show how much, if any, was after-tax contributions, the IRS would not know because, unlike the IRA contributions, they are not reported to the IRS.

Thanks, I'll get my friend to check his 401(k) correspondence.  Failing that, he can contact Fidelity.