US tax on UK pension 25% tax free lump sum

I expect this has been discussed before, but I am looking for a definitive reference that answers the question of whether or not the 25% tax free lump sum that a UK resident US taxpayer might take on retiring with a UK defined benefit pension scheme is or is not US taxable. It has been suggested to me that the savings clause in Article 1(4) of the UK-US Convention says that the US "by reason of citizenship *may* tax its citizens, as if this Convention had not come into effect", and that the word "may" leaves the IRS discretion, and thus that they may choose not tax such a lump sum (i.e. to not activate the savings clause.) One person tells me that they have been told by an IRS agent, after extensive telephone conversation, that such a lump sum from a final salary scheme will not be taxed by the US. The advice from the IRS agent was "If it is not taxable in the UK then it is not taxable in the US."

If the advice from that IRS agent is correct then it is good news. However, lump sums are mentioned in Article 17(2), which is a paragraph which is not excluded from the savings clause by Article 1(5). This is explained at the end of a page of HMRC advice: http://www.hmrc.gov.uk/manuals/dtmanual/dt19876a.htm. I have heard of US persons in the UK shying away from taking a lump sum on retirement because of they believed US tax would be payable. Were they advised over-cautiously? What is the truth of the matter? Is it a grey area, such that some IRS enrolled agents do have their clients paying US tax on these pension lump sum payments, while others do not?

I found this letter from the Office of Chief Counsel, Department of the Treasury and think it may answer my question. http://www.irs.gov/pub/irs-wd/08-0024.pdf

It is about the tax treatment of a lump-sum distribution from a qualified U.K. pension scheme paid to a U.S. resident. The key thing is that the person is a U.S. taxpayer, and so the same answer would apply to the case of a distribution to a U.S. taxpayer resident in the U.K.

The chart here is also helpful. http://intltax.typepad.com/894_pension_taxation_uk.pdf.

The general consensus is that UK pension lump sum payments are fully taxable by the US when paid to a US tax resident or citizen. However, the definition of a lump sum is debated. If you were to take the lump sum over a number if years according to a distribution plan you could argue that you are taking income and thus any part that is UK tax free would also be tax free in the US


Sent from my iPhone using Tapatalk

I would like to add some comments to this interesting discussion.

Savings clause
The use of the word “may” in the savings clause is to ensure that the US is allowed to tax its non-resident citizens. It is not there to imply that the IRS might use a discretion on an individual basis.

Taxation of pension lump sum
The 1975 double tax treaty in relation to the taxation of pension benefits was amended when the treaty was updated in 2001. The US specifically changed the wording to prevent what it saw as the double non taxation of UK lump sum pension benefits.

Lump sum definition
The double tax treaty does not contain a definition of a lump sum. Nor is this covered in the Exchange of Notes or other material. Commentators have said that this was deliberate.

One textbook says: “in practice, it may be expected that the US will attempt to interpret this term so as to carry out its intent. That is, a “lump sum payment” may be interpreted to mean a pension payment that is not subject to UK tax because of the form of the payment.”

With the changes to the UK pension rules it's now possible to take the 25% lump sum over a number of years and you can also leave the taxable other 75% in the pension. As the IRS defines a lump sum distribution as taking the entire balance of the pension in a single year you can argue that a 25% tax free distribution is not a lump sum and is therefore not covered by Article 17(2) at all and is actually covered by Article 17(1). Using the same argument that makes a ROTH IRA distribution tax free in both the US and the UK the UK 25% tax free amount would also be tax free in the US. The key is how you take the distribution. As long as it can be treated as income rather than a lump sum it should be tax free. There is no ruling on this as far as I know, and others will know the most up to date references and thoughts on this, but it seems like a pretty straight forward application of IRS rules.

You can take Nun's view on lump sums if you wish, but the risk is clear from my above comments. The purpose of the 2001 amendments are made clear by US Senate and other commentary at that time.

You can take Nun's view on lump sums if you wish, but the risk is clear from my above comments. The purpose of the 2001 amendments are made clear by US Senate and other commentary at that time.

I'm not encouraging anyone to take any particular course. It's up to the individual (and their advisor) to file taxes to the best of their ability and understanding. I would use the IRS definition of a lump sum and describe the 25% tax free amount from the UK pension as income if the entire balance of the pension is not taken.

If you want to be really careful take the pension as a structured series of payments using something like a 72t approach so that 25% of each payment is tax free.

Could you point us in the direction of the IRS definition of a lump sum for these purposes?

Could you point us in the direction of the IRS definition of a lump sum for these purposes?

Well the IRS definition applies to US qualified plans so you could argue it deosn't apply to a UK pension, but it's a starting point

http://www.irs.gov/taxtopics/tc412.html

Thanks for a helpful thread. I have a related question: I am a US resident with a soon-to-mature UK pension. I have the option to take all or part as an annuity. I'm told the annuity will have UK tax deducted at source, but as I have no other UK income and the amount is small, I hope to prevent this. How can I do this, and if I cannot, can I assume that any UK tax I pay can be offset against my US tax liability?

Thanks for a helpful thread. I have a related question: I am a US resident with a soon-to-mature UK pension. I have the option to take all or part as an annuity. I'm told the annuity will have UK tax deducted at source, but as I have no other UK income and the amount is small, I hope to prevent this. How can I do this, and if I cannot, can I assume that any UK tax I pay can be offset against my US tax liability?

Be careful you understand the terms of the annuity. You might consider drawdown rather than an annuity.

As far as UK tax liability there is none. File a US-individual2002 form and you will be exempted from all UK tax on the income.

Thanks nun. The annuity is at 11.1% so it's attractive (assuming I survive another decade or so); but if I decide to take the 25% UK tax-free and pay tax on the remaining 75% in order to bring it all to the US to avoid exchange rate risk (either as a lump sum or over time), what are the UK and US tax implications?

Thanks nun. The annuity is at 11.1% so it's attractive (assuming I survive another decade or so); but if I decide to take the 25% UK tax-free and pay tax on the remaining 75% in order to bring it all to the US to avoid exchange rate risk (either as a lump sum or over time), what are the UK and US tax implications?

I assume the 11.1% is the payout rate....that sounds very high. How old are you? Is this a fixed income annuity or some variable annuity?

Well if you take all the UK pension out in a single year and bring it to the US you will pay US tax on the whole amount at your US marginal income tax rate because it will definitely be seen as a lump sum distribution by the IRS. If you can spread the payments out over a number of years there is an argument to be made that it is not a lump sum and you will then only pay US tax on 75% of the UK pension amount.

Yes, the annuity rate of 11.1% is high - fixed back in 1986 when I made the single contribution to the plan. I'm 64 so it matures next month. My inclination, based on what I've read and a spreadsheet model I made, is to take the 25% and put the rest into a lifetime annuity.

Yes, the annuity rate of 11.1% is high - fixed back in 1986 when I made the single contribution to the plan. I'm 64 so it matures next month. My inclination, based on what I've read and a spreadsheet model I made, is to take the 25% and put the rest into a lifetime annuity.

An 11% payout rate is excellent, was this a single premium deferred fixed annuity?