Early IRA Withdrawal for UK Citizen

Hi, I am seeking a wee bit of advice. I've read through some of the forum to try and get an answer and I 'think' I know what I should do with regards to my UK tax return.

My circumstance is that I'm a UK citizen and from 1996 through to 1999 I worked in the USA and during that time I contributed to a 401k plan. I then returned back to the UK and this year to fund a new business I had to unfortunately cash out my IRA(the 401k was ported to a IRA product).

Working through a basic example ...

Original contribution = $20,000
Fund value at termination = $100,000
Withheld at source (10%) = $10,000
Distribution amount = $90,000

Would the amount liable for UK taxation then be $70,000?

Also is there any real need for me to file a US tax return given the US Govt. has taken its money? 

If you elect into the treaty and it is an LSD (which it sounds like it probably is) it is only taxable in the United States. You would want to file a US return to get a refund based on these figures.

As the title includes "Early Withdrawal" I'm going to assume you are under 59.5 and you will have to pay a 10% penalty to the IRS. 401k contributions are usually made before tax so the entire amount of your IRA will be taxed as income.

You will have to pay a 10% penalty ($10k) to the IRS and because it is a lump-sum distribution you also have to pay US tax on $100k of income as an NRA, so you'll be in the 28% tax bracket and probably end up owing around $20k, but you'll be able to take a credit for the $10k withholding tax.

Strictly speaking I think you could also be taxed in the UK due to the saving clause and your residency, but I'm not sure whether HMRC takes advantage of Article 1.4. If it did you'd have to pay UK tax and then resource the IRA income so you can take a foreign tax credit on the US taxes.

Thanks for the information.

Yes - sorry I should have mentioned I am indeed below retirement age.

So it sounds like any monies I owe would be taxable in the US. Now I would have thought there would not be any double taxation and so therefore I would mention this in my UK tax return but would not expect to pay any taxes on it even though I am resident in the UK.

Does that summarize it accurately?

Thanks for the information.

Yes - sorry I should have mentioned I am indeed below retirement age.

So it sounds like any monies I owe would be taxable in the US. Now I would have thought there would not be any double taxation and so therefore I would mention this in my UK tax return but would not expect to pay any taxes on it even though I am resident in the UK.

Does that summarize it accurately?

Under US domestic law you are liable to tax on your IRA and must pay a penalty. If you elect the treaty, Article 17.2 also gives the US the sole right to tax your lump sum distribution. However, the saving clause in Article 1.4 also gives HMRC the right to tax the distribution as if the treaty was not in effect. Article 1.4 is usually there for the benefit of the US so they can tax their citizens, but as you are a UK citizen and resident the wording does give HMRC the chance to tax your IRA distribution too. I don't think HMRC bothers to enforce the saving clause, but you might double check with HMRC or a professional to make sure. Even if they did you would not be taxed twice as you could use foreign tax credits to defray tax in the US.

Thanks for the advice.

I've taken a look at the treaty and have also taken a look at the 1040NR and matching instructions which of course lead me to another form I need to additionally fill in, the 5329.

I was going to pay someone to do this all for me but by the looks of it, and thanks to your advice, I can give this a go myself.

From reading the above, it appears to me that the following scheme would work for a UK resident (either US citizen/resident or not):

• Take distribution from IRA, pay 10% penalty plus income tax on value (latter could be zero/not much for small funds or no/not much other income to include). No UK tax to pay.
• Pay the remaining funds straight into your UK pension and get tax relief.

This potentially seems like such an easy win that I must be missing something! For example, if one were to take a partial distribution each year that led to only the 10% penalty in the US, and could then get relief at 40% then that's a nice quick profit!