My contributions and employer contributions to UK pension

Hi All,

I've read several threads on here about dealing with UK pensions and US taxes.  I'm very far away from retiring, so right now, I'm trying to understand how to best handle the contributions. 

After doing what seems like a lot of research, I'm still confused.  This year I will be using form 1116 (Foreign Tax Credits) as opposed to 2555 as now that I've got a child (and number 2 on the way), it seems silly not to be getting money back from Uncle Sam.  My question on pensions though: can I include my pension  contributions as part of my gross income?  I'll list some numbers below to illustrate what I mean:

UK Gross Salary - £30,000/year
My pre-Paye tax free contribution to UK pensions  (6% of salary) - £1800/year
My employer contribution to UK Pensions (5% of salary) - £1500/year

It's my understanding that it's best to declare and pay tax on these pension contributions now rather than when I begin drawing on the pension.  The overall affect on my tax bill would be minimal even if I did have to pay something, but I just wanted to know if it's okay to include these contributions as part of my gross pay for form 1116 purposes, and then use leftover Foreign Tax credits (from paid UK income tax on my actual wage) to offset any US tax.  To me, this seems logical as they are payments made as part of my pay packet, but just into a different account that I can't touch for a long time.  Does the IRS see it this way? As it seems advantageous to me, I doubt the IRS does see it this way

Any guidance greatly appreciated. 

Regards,
Sam

My understanding is that your contributions count as part of your gross income, but employer contributions are unearned income according to the US.

I'm intrigued by this too.

If you don't (or can't) take the treaty exemption and include your UK tax deferred contributions and employer contributions on your 1040 and pay US tax on them, how do you then treat gains and the eventual pension income for US tax purposes? Seems there's going to be some calculation involved to account for all the taxed principal payments....would it be treated like an annuity you paid for with after tax money?

Well, if I can't include the employer contributions as part of my gross, I'll just put them as other unearned but taxable income (line 22 on 1040?, where you put your negative number from your form 2555 if you use one of those).  For me, everything works out so that I'll just lose some money on my refund.  I still won't have to pay tax in practice.  But I hope to be earning big money soon (ha!), so knowing how to be most tax efficient with this source of money is advantageous. 

Regards,
Sam

If you don't (or can't) take the treaty exemption and include your UK tax deferred contributions and employer contributions on your 1040 and pay US tax on them, how do you then treat gains and the eventual pension income for US tax purposes?

My understanding: (As always, it could be wrong.)

If you declare your contributions on 1040 each year, and pay(?) tax on them, when you start claiming the pension you can deduct your previous taxed contributions as 'costs' to reduce the reportable amount of the pension for tax. You'll be able to take credits for the contributions when made, and reduce taxable income when retired.

If you don't pay tax on your contributions as they arise, when you retire you can not deduct your previous contribution amounts to reduce the taxable pension (as I read 939).

The other consideration at time of retirement is which method do you use to claim the 'costs', the general rule or the simplified method. This is determined by a foreign pension being qualified, or not, for the purposes of the simplified method. Generally, foreign pensions are not qualified, so you use the general rule (Publication 939). But, you may feel that the US/UK Treaty says that foreign pensions similar to US qualified pensions are deemed qualified. Back to interpretation of the Treaty.

Some feel it easier just to use the general rule, thereby avoiding any discussion of the Treaty (and its proper/acceptable use), since in the end there may be little between the results for the two methods.

Currency fluctuations will play a part regardless of which method you use, since calculations are tied to the first year of retirement. Because of what is, or more importantly isn't, in the text of the general rule, it could be yield a better result long term. If the pension has a survivors clause, that will also impact calculations for both methods.

As for the handling of the employers contribution after retirement, I've found an IRS interpretation doesn't always agree with a professional opinion. One method may be to declare your contributions, but invoke the Treaty for the employers contributions since you haven't paid any foreign tax on it and the employer hasn't paid any tax on it to the US (the sticking point for the IRS). I'm sure there may be further comments on this from others.   

This might help.

Taxation of Pension Contributions

Article 18 of the Tax Treaty deals with cross-border pension contributions and is generally intended to remove barriers to the flow of personal services (i.e., employees) that could otherwise result from differences in the US and UK laws regarding the deductibility of pension contributions. This is the first US tax treaty to allow US citizens residing in another country to deduct, for US tax purposes, contributions made to a foreign pension plan.

US Citizens Residing in the UK and Participating in a UK Pension Plan. The Tax Treaty allows US citizens resident in the UK to deduct, for US tax purposes, contributions to a pension plan established in the U.K. This deduction is only available while the US citizen continues to reside in the UK. The US citizen’s deduction is limited to the lesser of (1) the amount deductible in the UK for contributions and benefits under a UK-established pension scheme and (2) the amount that would be deductible in the US for contributions and benefits to a generally “corresponding pension scheme” established in the US. In addition, US citizens will not be taxed by the US as the pension benefit accrues, provided the UK-established pension scheme is a generally “corresponding pension scheme” (as described below).

Corresponding Pension Schemes. The Notes to the Tax Treaty state that “corresponding pension schemes” include:

In the UK: (1) Approved employment-related retirement benefit schemes (for purposes of Chapter 1 of Part XIV of the Income and Corporation Taxes Act of 1988) and (2) Personal pension schemes approved under Chapter IV of Part XIV of such Act).

In the US: (1) Qualified plans under IRC § 401(a), e.g., 401(k) plans, (2) Individual Retirement Accounts (including traditional, SEP and Roth IRAs) and (3) Qualified plans under IRC § 403(a) and (b).

Thanks Barcrest, using the treaty is one approach, but the OP is proposing an alternative where contributions to foreign pensions are declared on the 1040 and tax credits are used to pay the US tax due. If you work things correctly excess credits deal with the tax on the contributions so you have a UK pension who's principal payments have already been taxed by the US. So you only pay tax on the gain when you take income. So the next question is if you don't invoke the treaty for contributions do you still invoke it to keep any gains US tax free while the pension id growing? Of course when you eventually take income you have to calculate how much of you pension income is return of already taxed capital and how much is yet to be taxed gain.

As an aside, I've read that the UK pension industry does not perform well and it will be interesting to see the sort of numbers that pop out of the calculation you have to do for the IRS to get the real rate of return on a UK pension plan.

Thanks Barcrest, using the treaty is one approach, but the OP is proposing an alternative where contributions to foreign pensions are declared on the 1040 and tax credits are used to pay the US tax due. If you work things correctly excess credits deal with the tax on the contributions so you have a UK pension who's principal payments have already been taxed by the US. So you only pay tax on the gain when you take income. So the next question is if you don't invoke the treaty for contributions do you still invoke it to keep any gains US tax free while the pension id growing? Of course when you eventually take income you have to calculate how much of you pension income is return of already taxed capital and how much is yet to be taxed gain.

As an aside, I've read that the UK pension industry does not perform well and it will be interesting to see the sort of numbers that pop out of the calculation you have to do for the IRS to get the real rate of return on a UK pension plan.

Sounds complex. How would you calculate the pension part that had already been taxed?

Right, I will need to keep this brief.

Yes this can be done and it is great tax planning.  However it is really only worthwhile if you expect to retire in the US.

The "normal" way of handling pensions is to deduct your pension contributions, reducing your gross income, and also excluding your employer contributions.  This is actually allowed under the treaty, though most people don't think of it this way.

If you wanted to get clever, you can choose not to use the treaty.  You don't deduct your contrubutions from income and you include your employer contributions as income.  You use your excess foreign tax credits to cover the US tax liability on the higher income -- in effect making the additional income feel like it is tax free.

When you come to retire, you have already paid tax on the -ee and -er contributions so you don't pay it again.  For example, assume you contributed $3000 and your employer contributed $7000 - you have used your excess credits to cover the US tax.  You earn $1000 on the $10000 in contributions and now you are retiring.  As you take out the pension monies, you are only taxed on $1000/$11000, because you have already paid tax on the $10000.

As I alluded above, this is only a US view and assumes you are retiring in the US.  If you retire in the UK, it doesn't work like this.  You also have to keep GOOD records, for possibly decades.

All perfectly acceptable and a fairly common bit of tax planning.  

If you wanted to get clever, you can choose not to use the treaty.  You don't deduct your contrubutions from income and you include your employer contributions as income.  You use your excess foreign tax credits to cover the US tax liability on the higher income -- in effect making the additional income feel like it is tax free.

So how do you deal with the US tax on the gains during the accumulation phase? Do you invoke the treaty for those?

Also if you have a defined benefit pension the calculation of the return of capital and gain will involve some actuarial mathematics.

Yep, earnings are deferred until you start taking pension distributions. And yes this is specific to DC scheme.

Sarah - why wouldn't it work for a DB scheme? For ex, The total after-tax contributions are $50,000. The value of the fund at retirement is $200,000, consisting of 20 yrs. payment of $10,000. Why couldn't the taxable portion of the yearly $10,000 be reduced by 25% (ie, the ration of the after contributions to fund value).

Sarah Smile, Thanks for clarifying in an easy to understand posting. You learn something new every day!

Can I piggy-back on this with a question? I will be giving up my US citizenship later this year, so I'm not concerned about long-term tax planning. Therefore I would like to claim the treaty exemption so I don't have to report my employer contributions; this is because I'm now married filing separately, which means I can't claim the student loan interest that has previously counterbalanced the tax that would be due on those contributions. I'm in a weird situation where I think I actually pay less tax here than I would on the exchange rate value of my salary for the US (20% bracket here, 25% bracket there), so I'm not sure using the FTC would benefit me. How do I actually go about claiming the treaty on my return?

Sarah - why wouldn't it work for a DB scheme? For ex, The total after-tax contributions are $50,000. The value of the fund at retirement is $200,000, consisting of 20 yrs. payment of $10,000. Why couldn't the taxable portion of the yearly $10,000 be reduced by 25% (ie, the ration of the after contributions to fund value).

I was thinking of the final salary type of DB plan where you get a pension for life. For that, as theOAP has previously discussed, you'd have to use either the Simplified or General IRS rule for calculating the tax free cost basis of the pension

http://www.irs.gov/publications/p575/ar02.html#en_US_2011_publink1000226781