How do contributions to employer pension schemes work?

Hi all,

I have a tax question which I hope will be straightforward, as I'm sure it's a common situation. I am a US citizen living and working in the UK. My pay stubs state my UK-taxable income, let's call this X. They also state my contribution to an employer pension scheme (which is deducted from my total salary, and which is not part of my UK-taxable income), let's call this Y.

For the purposes of reporting my foreign earned income on my U.S. tax return, Googling around turned up this part of the US-UK tax treaty as relevant -- it's talking here about employer pensions established in the UK:

"(i) contributions paid by or on behalf of that individual to the pension scheme during the period that he exercises the employment in the United Kingdom, and that are attributable to the employment, shall be deductible (or excludable) in computing his taxable income in the United States; and
(ii) any benefits accrued under the pension scheme, or contributions made to the pension scheme by or on behalf of the individual’s employer, during that period, and that are attributable to the employment, shall not be treated as part of the employee’s taxable income in computing his taxable income in the United States."

My interpretation of this is that:
- if I take the credit, I report X + Y as my income but can deduct Y (how? I assume just by putting it in box 2 on form 1116)?
- if I take the exclusion... then I report X + Y as my income and exclude as much of it as the cap allows? Or does excludable in this context mean that I can choose only to report X?

I found this post newcomer link: https://ttlc.intuit.com/community/taxes/discussion/re-foreign-income-pension/01/1412262/highlight/true [nonactive] where someone seems to imply that it's possible only to report X, but at the cost of a "later burden of zero basis in your distributions", a phrase which I admit my non-accounting brain is having difficulty understanding even after a little Googling around!

Thanks for any assistance!

drgold, are you over-complicating matters? Or at least misinterpreting?

You quote the Treaty. At the start of (i) it says " contributions paid by or on behalf of that individual to the pension scheme" and accordingly I think it is clear, they are talking about not just talking about employer's contributions "paid .... on behalf of" but also contributions made by you "contributions paid by .... that individual". So both employer's and employee's contributions.

And then later on in (i) it says "shall be deductible (or excludable) in computing his taxable income in the United States". So isn't it clear, just do not include pension contributions paid by either you or your employer. So, using your lettering, just treat X as your pay to report for US tax purposes.

And then (ii), I think that is merely making clear that everything that happens within your "pension pot", that is not income for US tax purposes.

But I have to admit, your paragraph that starts "I found this post newcomer link ..... " that is is not understood by me.

My understanding of your last comment is that if you only report X as taxable income, then later, once you start to receive your UK private pension, it would be taxable in USA (like 401K  - you put Y into pension account tax free, but you then pay tax when you take money out).
If however you report X+Y as your taxable income for US purposes, then your UK private pension scheme will become only partially taxable in USA (like Roth). 
I guess the part of that UK pension which comes from UK employer contribution would still be taxable in US..
Here:
https://thunfinancial.com/home/american-expat-financial-advice-research-articles/the-foreign-pension-plan-dilemma-for-american-expats/?gclid=Cj0KCQjwiYL3BRDVARIsAF9E4GcspOnDvTH2-tz6g8IrQlyGtG5hu_q2GRRnyTW6M68V0ItyeSljFCAaAhG7EALw_wcB

Probably one can even report employer contributions Z as taxable income as well, and then get pension fully free from US tax..
Given earned income allowance and high tax rates in UK, it is probable that for many people reporting X+Y+Z would not increase US tax..

P.S. If you want to exclude Y from US income, I think you may only exclude up to amount allowable in US (not sure what it is now - 15K per year?)

Thanks very much, JohnL and obormot. JohnL: it's absolutely possible that I am misinterpreting or overcomplicating matters. However I wasn't confused about which money (i) and (ii) were referring to, just was a little confused about what it meant that this income was "excludable". "Excludable" as in, (A) you can use the Foreign Income Exclusion on it (which would still mean paying tax on the amount that exceeds the cap)? Or as in (B) you can treat it as if you didn't even earn it (which is what it sort of sounds like... but in that case, why wouldn't they have just used the wording they used in (ii), "shall not be treated as part of the employee’s taxable income")?

obormot: Thank you - that seems consistent with my limited understanding of the thread I linked, and was my wife's interpretation as well, so I think that's right (at least with respect to X & Y, less sure about Z). And I think your P.S. corresponds to what I described as (A) in the above paragraph, which is what I was thinking might be the case. Anyway, I think whether to report Y will turn out to be a question of primarily academic interest for me this year as it looks like reporting X+Y will still keep me below the cap, so it seems like there's no reason to consider doing otherwise.

If anyone happens to know how one should deduct pension contributions if opting to take the Foreign Tax Credit (is it deduction box 2, "Expenses definitely related to the income on line 1a"?), that'd be great to hear and perhaps useful for others who stumble across this thread! But again, probably of academic interest for me, as I am pretty sure I will be better off taking the exclusion anyway.

"later burden of zero basis in your distributions"
I'll take a stab at this. I think it means when you start taking money out you are taxed on the entire amount.

The basis would mean the amount you had contributed to the pension. That statement is saying you would have zero basis.

If your pension total value was A, and your contribution to that pension was B (your basis) on withdrawal you are only taxed on the value of A-B, i.e. the profits you have made. Let's call that C. You are allowed 25% free of any withdrawal (some argue it has to be periodic) and I have been advised that there is no stipulation as to which part of your distribution (B or C) that 25% can apply to. So for each withdrawal I make I claim 25% of the withdrawal is from C, and apply the 25% tax free per the treaty to that. The remainder I say is return of B so it's all tax free. I might run out of the B pot eventually but I can probably increase the C portion as I have room for more income before paying tax. Well at least that's how I think it all works - my accountant has a spreadsheet.

A

Obormot:

You said this:

"Probably one can even report employer contributions Z as taxable income as well, and then get pension fully free from US tax.."

I think another complication is the profit within the pension. Do you declare that on a yearly basis? I list in on an 8833 stipulating it is covered by the treaty and not taxable but I have read elsewhere that's unnecessary. But I have to take this into account on withdrawal. I suppose if you declare that as income as well you wouldn't worry about that.

"later burden of zero basis in your distributions"
I'll take a stab at this. I think it means when you start taking money out you are taxed on the entire amount.

The basis would mean the amount you had contributed to the pension. That statement is saying you would have zero basis.

If your pension total value was A, and your contribution to that pension was B (your basis) on withdrawal you are only taxed on the value of A-B, i.e. the profits you have made. Let's call that C. You are allowed 25% free of any withdrawal (some argue it has to be periodic) and I have been advised that there is no stipulation as to which part of your distribution (B or C) that 25% can apply to. So for each withdrawal I make I claim 25% of the withdrawal is from C, and apply the 25% tax free per the treaty to that. The remainder I say is return of B so it's all tax free. I might run out of the B pot eventually but I can probably increase the C portion as I have room for more income before paying tax. Well at least that's how I think it all works - my accountant has a spreadsheet.

A

My understanding is that calculating the tax-free part that represents basis is done using the "general rule". 

Obormot:

You said this:

"Probably one can even report employer contributions Z as taxable income as well, and then get pension fully free from US tax.."

I think another complication is the profit within the pension. Do you declare that on a yearly basis? I list in on an 8833 stipulating it is covered by the treaty and not taxable but I have read elsewhere that's unnecessary. But I have to take this into account on withdrawal. I suppose if you declare that as income as well you wouldn't worry about that.

Section 402(b) is pretty clear. Only "highly compensated" employees include growth in the plan as US taxable income each year.

Guya,

Thanks for that comment re the "general rule". I'll pass that onto my accountant. I have a SIPP but some contributions were made by my employer -I suppose I should distinguish between employer contributions and employee contributions RE the basis.

In a different message you mentioned "highly compensated" employees are the only people who should declare the profit. What happens if you were a highly compensated employee subsequently retired - the profits still accrue and don't need to be included in income?

Cheers

A