How to handle employer pension contributions

Hi all,

I have a specific question about how to handle my employers pension contributions on my US taxes.

I am taking the view that my employer pension is covered by the treaty, and so my first option is to put my gross salary in FEIE (which I understand cannot include employer contributions) and ignore the employer contributions.

However, I understood that if employer contributions could be counted as taxed it would be counted somehow when taking distributions from the pension. So I thought this would be preferable if it can be done without incurring too much of an extra tax burden now.

I looked at foreign tax credits, but I think with the employer contributions being quite generous (16%) the UK income tax (I understand you cannot include national insurance) did not cover it and I ended up with ~$2k bill.

Alternatively, if I just declare the employer contributions as other income, and use the FEIE for everything on my payslips I end up with a tax bill of ~$140 (vs $0 obviously if I use the treaty to ignore my employer contributions).

I was wondering if anyone could provide advice on whether it is worth paying this $140 to have ~$8.5k greater basis in the (USS) pension. I guess I have no intuition of what difference it will make in the future - eg whether the tax owing on these original contributions is a bit meaningless because by the end inflation will make them so small that it won't make any difference if this $8k from 2013 was taxed or not? (I am 30+ years from retirement).

Would people think it is worth doing or not?

The 16% you refer to for the USS is not quite accurate; as section 402(b) requires you pay tax on the vested accrued benefit (VAB). You'll need to figure out the VAB and then report this amount as income that does not qualify for section 911 exclusion.

Your comments sound as if you are probably also overlooking the effect of the stacking rule.

So if after 1 year of pension participation you would be entitled to, say, 1% of your income starting at age 65 do you just add 1% to your foreign earned income?

If after 2 years you pension calculation gives you 2% of your income at age 65 do you add 1% or 2% to your foreign earned income?

A few other thoughts that come to mind while we're on this subject:

Defined contribution plans - since benefit is entirely dependent on investment performance, is the concept of VAB relevant at all? In those cases wouldn't the amount of income you report simply be the dollar amount put in by the employer?

SMART schemes - HMRC recognize that the employee is making a salary sacrifice in exchange for an equivalent employer pension contribution. This saves on NI and eliminates the need to claim the tax relief on a self assessment return. However, would the IRS also treat these contributions as made by the employer or would they be deemed employee contributions under US law?

Thanks for the replies.

The 16% you refer to for the USS is not quite accurate; as section 402(b) requires you pay tax on the vested accrued benefit (VAB). You'll need to figure out the VAB and then report this amount as income that does not qualify for section 911 exclusion.

I am not trying to have a 100% taxed basis in the pension. My Vested accrued benefit each year would be 1/80 salary x 30 year standard annuity multiplier + 3/80 lump free tax sum  = 41% of salary not including inflation adjustments for previous years, which is obviously going to increase my tax burden a lot. So I plan to use the treaty protections to allow the "gains" within the pension to be untaxed now and pay income tax when I receive benefits. Using the treaty I would normally just complete exclude the employer contributions - keeping a note of the amount of contributions made under different status'. Eg my personal contributions are always post-tax (because I am not deducting them - they come from income in my FEIE) which the employer would be pre-tax (because it cannot be included in the FEIE). I just thought since it would not cost me anything to declare the employer contributions so they are post-tax, this could be an advantage - it would increase my tax-free basis in the pension which would be use to calculate tax owing when I start receiving distributions.

It is not clear what you are suggesting - but if this is not possible then I would return to the standard treaty approach of not declaring employer contributions at all. Do you think that is better?

Your comments sound as if you are probably also overlooking the effect of the stacking rule.

Probably! Could you provide any more information or reference about what this refers to?

So if after 1 year of pension participation you would be entitled to, say, 1% of your income starting at age 65 do you just add 1% to your foreign earned income?

I am not planning to add anything to my foreign earned income. I know I cannot add employer contributions, so I am not sure how I could add vested accrued benefit.

SMART schemes - HMRC recognize that the employee is making a salary sacrifice in exchange for an equivalent employer pension contribution. This saves on NI and eliminates the need to claim the tax relief on a self assessment return. However, would the IRS also treat these contributions as made by the employer or would they be deemed employee contributions under US law?

I am pretty sure this is how I am paid - my personal contributions are deducted on my paylsip before NI. I had no idea this could have further influence! If it would be considered employer contributions then it could no longer be included on the FEIE, where at the moment I am listing my gross salary received.

Thanks for the replies.

I am not trying to have a 100% taxed basis in the pension. My Vested accrued benefit each year would be 1/80 salary x 30 year standard annuity multiplier + 3/80 lump free tax sum  = 41% of salary not including inflation adjustments for previous years, which is obviously going to increase my tax burden a lot.

Surely that's your VAB after 30 years.....not one year.

say you earn 80k a year, after one year your benefit would be
1/80 x 80k + a lump sum of 3 x (1/80 x 80k) = 1000GBP plus a 3000GBP lump sum.

For year two you need to calculate the new pension amount.....and I think you'd pay tax on the accrual from year one ...ie the difference between year 2 and year 1. I'm not sure how you deal with the lump sum.

Surely that's your VAB after 30 years.....not one year.

say you earn 80k a year, after one year your benefit would be
1/80 x 80k + a lump sum of 3 x (1/80 x 80k) = 1000GBP plus a 3000GBP lump sum.

No I think that would be VAB for one year. The 1x80 is like an annuity - it is a sum which is paid out every year of retirement. According the USS guidelines and what little I could find from the IRS a good first order approximation for the average duration of an annuity is 30 years (as I say this is what USS use). So from my 1 year of service, I will receive 1/80 of salary *for thirty years from retirement*. Hence the capital value of the pension is 30/80 + 3/80 lump sump accrued that year.

Bear in mind this is a university pension so 80k is not such a realistic salary But I stand by the point after one year I would have earned an annuity of 1000GBP (capital value ~30k), plus a lump sum of 3000GBP. So I believe that my VAB would be 33k. In the second year, I would accrue another 1000GBP of annuity (capital value 30k), another 3000GBP lump sum, plus the say 4% inflation adjustment to the previous year (£1320 from the 33k in year one).

In any case, there is no way I am paying tax on the VAB - as I will of course use the treaty provision. My question remains - does it pay to make more "contributions" which I am keeping track off post-US tax or does it not make any difference.

No I think that would be VAB for one year. The 1x80 is like an annuity - it is a sum which is paid out every year of retirement. According the USS guidelines and what little I could find from the IRS a good first order approximation for the average duration of an annuity is 30 years (as I say this is what USS use). So from my 1 year of service, I will receive 1/80 of salary *for thirty years from retirement*. Hence the capital value of the pension is 30/80 + 3/80 lump sump accrued that year.

I think you are wrong there simply because your tax bill over the years will be astronomical.

I think you are wrong there simply because your tax bill over the years will be astronomical.

I do appreciate your input, but this is one point on which I am not uncertain! The USS documentation is quite clear and explicitly defines what they call the "accrued capital value" of the plan in very clear terms. I understand it is an unusually generous plan - and hence it would be very difficult to pay tax on the accrued benefits each year - but since it is definitely covered by the treaty I will only pay income tax on distributions.

But this has very much sidetracked from my original question which was about contributions, post-tax and pre-tax. I understood that when I start making distributions from the plan, the amount of post-tax contributions I had made would be factored in, and therefore that it might be beneficial now to make the employer contributions after US tax to increase this tax free basis. I am only interested in this because of the 3x pension value lump sum which is tax free in the UK but taxable in the US. If I can reduce the tax liability on this by eg paying the $140 this year so employer contributions are after tax I would like to do it. Can anyone offer any advice specifically on this point?

I believe that the vested accrued benefit (assuming immediate vesting) would be the present value of the expected annual pension payment at retirement.

I believe that the vested accrued benefit (assuming immediate vesting) would be the present value of the expected annual pension payment at retirement.

OK - as I said I was thinking of accrued capital value. I am amazed that defined benefit schemes would be treated so much more favorably than defined contribution (ie taxed on 1x year benefit rather than full capital value which is 30x more).

Again though I find something stuck for knowing what to do. Whatever the VAB is - where should it go? I can not find any information on where/how to declare it (which form etc.). I can find nothing from the IRS actually about a vested accrued benefit.

As I said I am looking to take the view that my pension is covered under the treaty - but I remain unsure whether/where to declare the employer contributions.

Having received so much contradictory advice (I paid a qualified advisor who told me to put everything in FEIE I know that is wrong, the IRS in London advised me to ignore employer contributions that do not appear on my pay slip) I would just like to find someone to suggest how I should declare the employer contributions...

Since you have tax adviser who will sign the returns as preparer you should ask her how she normally calculates VAB and what sections of the IRS code and Regulations she is using to undertake these calculations; and what line of the form she is using and again what sections of the IRS code and Regulations she is relying on to reach that decision. Please let us all know once you have found out.

Since you have tax adviser who will sign the returns as preparer you should ask her how she normally calculates VAB and what sections of the IRS code and Regulations she is using to undertake these calculations; and what line of the form she is using and again what sections of the IRS code and Regulations she is relying on to reach that decision. Please let us all know once you have found out.

I do not currently have a tax preparer - I paid one last year who gave incorrect advice.

After extensive searching on the internet the only references I have found to the terms "Vested Accrued Benefit", VAB in relation to the IRS and taxes are posts that come directly from you (guya). Could provide any external link to any information (in one post you referenced secion 165(c), but again I am unable to find anything numbered 165 which relates or refers to vested accrued benefit)?

You have said several times it is a legal requirement to provide this with a filing. Could you briefly say where and how one should do this, or perhaps provide a link to any IRS information on the subject?

Thanks

http://www.law.cornell.edu/uscode/text/26/402

U.S. Code § 402 - Taxability of beneficiary of employees’ trust

(a) Taxability of beneficiary of exempt trust
Except as otherwise provided in this section, any amount actually distributed to any distributee by any employees’ trust described in section 401 (a) which is exempt from tax under section 501 (a) shall be taxable to the distributee, in the taxable year of the distributee in which distributed, under section 72 (relating to annuities).
(b) Taxability of beneficiary of nonexempt trust
(1) Contributions
Contributions to an employees’ trust made by an employer during a taxable year of the employer which ends with or within a taxable year of the trust for which the trust is not exempt from tax under section 501 (a) shall be included in the gross income of the employee in accordance with section 83 (relating to property transferred in connection with performance of services), except that the value of the employee’s interest in the trust shall be substituted for the fair market value of the property for purposes of applying such section.
(2) Distributions
The amount actually distributed or made available to any distributee by any trust described in paragraph (1) shall be taxable to the distributee, in the taxable year in which so distributed or made available, under section 72 (relating to annuities), except that distributions of income of such trust before the annuity starting date (as defined in section 72 (c)(4)) shall be included in the gross income of the employee without regard to section 72 (e)(5) (relating to amounts not received as annuities).
(3) Grantor trusts
A beneficiary of any trust described in paragraph (1) shall not be considered the owner of any portion of such trust under subpart E of part I of subchapter J (relating to grantors and others treated as substantial owners).
(4) Failure to meet requirements of section 410(b)
(A) Highly compensated employees
If 1 of the reasons a trust is not exempt from tax under section 501 (a) is the failure of the plan of which it is a part to meet the requirements of section 401 (a)(26) or 410 (b), then a highly compensated employee shall, in lieu of the amount determined under paragraph (1) or (2) include in gross income for the taxable year with or within which the taxable year of the trust ends an amount equal to the vested accrued benefit of such employee (other than the employee’s investment in the contract) as of the close of such taxable year of the trust.
(B) Failure to meet coverage tests
If a trust is not exempt from tax under section 501 (a) for any taxable year solely because such trust is part of a plan which fails to meet the requirements of section 401 (a)(26) or 410 (b), paragraphs (1) and (2) shall not apply by reason of such failure to any employee who was not a highly compensated employee during—
(i) such taxable year, or
(ii) any preceding period for which service was creditable to such employee under the plan.
(C) Highly compensated employee
For purposes of this paragraph, the term “highly compensated employee” has the meaning given such term by section 414 (q).

The VAB language states specifically that it only covers Highly Compensated Employees - see boldfaced text:

(4) Failure to meet requirements of section 410(b)
(A) Highly compensated employees
If 1 of the reasons a trust is not exempt from tax under section 501 (a) is the failure of the plan of which it is a part to meet the requirements of section 401 (a)(26) or 410 (b), then a highly compensated employee shall, in lieu of the amount determined under paragraph (1) or (2) include in gross income for the taxable year with or within which the taxable year of the trust ends an amount equal to the vested accrued benefit of such employee (other than the employee’s investment in the contract) as of the close of such taxable year of the trust.

The definition of a Highly Compensated Employee is an individual who:

• Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
• For the preceding year, received compensation from the business of more than $115,000 (if the preceding year is 2012 or 2013), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.

We know that the OP works at a university so in my opinion he/she is very unlikely to be an HCE (although I suppose it is possible!). Guya, thanks for providing a proper citation to support your argument, but in view of these details, do you still feel the VAB provisions apply to the OP?

Other views are welcome.