Dual-taxation treaty - UK treatment of US tax witheld, for UK resident?

OK, I am still trying to figure out the best tax strategy for withdrawing funds from my US 401a retirement fund.

It was originally looking like I would simply wait until 59.5 and take lump sum withdrawals, claiming zero IRS withholding as a UK citizen, UK resident (since 2006), non-US citizen/resident.

For reasons to do with using my 2012-2013 carry-over UK annual pension allowance, it may be beneficial for me to start withdrawing from my US retirement fund before age 59.5. I realise that this comes with a 10% penalty. Here are my questions:

1) Is this penalty counted as a form of income tax? (I see it referred to as a "tax" on various sites and forums, but is rather unclear if this is classified as "income tax").

If so, can this be counted against my UK tax liability? In other words, to give a scenario for a UK 20% income tax payer (I'm deliberately ignoring the 90% rule for now, because it makes for simpler maths):

Withdrawal of $20k from US would be liable to 20% UK income tax.

IRS would take $2k (10% penalty) in "tax".

So, normally, HMRC would say "$20k income, $4k income tax"

Could I, via a self-assessment, say under the terms of the dual taxation treaty "IRS already took $2k, so I only owe $2k to HMRC"?

... if so, this seems a convenient way to mitigate the 10% penalty, but it is one of those "Too good to be true" things ...

[ETA: On the subject of "seems too good to be true", I presume W8-BEN can't be used to claim exemption from the 10% early withdrawal penalty "tax" ...? Nah, thought not]

BTW, I have really tried to find the answer to this online but everything that comes up seems to be designed for US expats living overseas ... sorry, I know I am not a US expat, but this place seems to be the only forum with people who have knowledge in this area.

Nice try......no I don't think you can use the early withdrawal penalty to offset UK tax. As a UK resident you pay tax on your US pension to the HMRC and then you can use the UK tax paid to offset any US tax due.......not the other way around. The UK is under no obligation to give you any credit for US tax you pay on your IRA distributions. This is why the US has a "resourced by treaty" basket on the 1116 form. It allows the US to consider things like IRAs owned buy people living outside the US as foreign income sources and, therefore, you can get a foreign tax credit for what is actually US source income. I think there's also an argument that the penalty isn't even a tax and so you'd get no credit.

What do you mean by "lump sum withdrawals"? I'm asking because I have never got a good explanation of how lump sum is used in the DTA. The IRS usually takes it to mean you take the entire balance of an account all at once. The UK has things like "25% lump sum"....if you take money out once a year for a number of years greater than one, that looks like a periodic distribution to me.

Finally you can avoid the 10% penalty by doing a 72t "substantially equal amounts" distribution up to age 59.5.

Nice try......no I don't think you can use the early withdrawal penalty to offset UK tax because it's a penalty in addition to the tax due. The UK doesn't have to give you credit for charges imposed....just the tax.

What do you mean by "lump sum withdrawals"? I'm asking because I have never got a good explanation of how lump sum is used in the DTA. The IRS usually takes it to mean you take the entire balance of an account all at once. The UK has things like "25% lump sum"....if you take money out once a year for a number of years greater than one, that looks like a periodic distribution to me.

Finally you can avoid the 10% penalty by doing a 72t "substantially equal amounts" distribution up to age 59.5.

Bugger, figured as much, although the IRS refers to it as tax and not a penalty (e.g., "Distributions received before age 59½ are subject to a 10% additional tax unless an exception applies." from http://www.irs.gov/taxtopics/tc424.html)

I agree with your point about the term lump sum -  yet another term that is used differently (re: US distributions) depending on where you read - though I think what you said above (taking "the whole pot in one go") appears most often as the definition. I was really just meaning "big chunks" rather than monthly distributions or an annuity.

I have been looking at the "substantially equal amounts" method, but I don't think it will work. The amounts are calculated based on your life expectancy, so would be quite small, proportionally, as they need to be spread out between now and expected death (at least if I am understanding what I have read correctly). You can't modify the annual amount without incurring retrospective (retroactive?) penalty being applied until 5 years after you start taking the "substantially equal amounts" distributions (or 59.5, whichever is the later/longer)

I need to take about 25% of my pot in one go. Essentially, to give some background, I am end-loading my UK pension contributions before I retire from my job in 3.5 years and I have a substantial carry-over annual allowance this tax year and next. I want to pay my whole salary into occupational pension, AVCs and SIPP this year (which I will be able to do) and next, but I can't afford to do it next year without an alternative source of living costs. I reach age 59.5 in October 2016 (i.e., 6 months after the end of tax year 2015-2016). The other option is to raid my ISAs and then gradually rebuild them, but I really don't want to use up about £20-£25k of past ISA allowance. Another alternative is to take out a short-term (6-8 months) low-interest loan and then pay it back when I pull the "sizeable chunk" from my 401k ... in fact, the charges and interest on a loan might be preferable to losing £25k of past ISA allowance.

Interestingly, TIA-CREF's take on it was that "you would be subject to a 10% early withdrawal penalty.  This would be imposed the IRS at the time of your tax filing."

- so I wonder, what would be the case if I don't file taxes, as a non resident?

Also, TIAA-CREF's use of the terminology of lump sum was "The rules of the Tennessee Optional Retirement Plan (TN ORP) allow take a lump-sum withdrawal or rollover of up to 50% of your TN ORP balance." ... though I think this is more of a restriction in my TN plan than some definition of the IRA's understanding of "lump sum"

Bloody TIAA-CREF. Tried to get them to clarify/confirm my situation regarding exemption from tax withholding based in the double agreement. They had previously said on two occasions that non-resident aliens were subject to 30% Federal tax withholding at source on pension income. So, with Nun's help I sent a message citing the relevant sections of the DTA.

Took them 2 weeks to reply, and the reply was "We have sent it to our tax department". Well, their tax department sent me this letter today:

"I am writing as a follow up to your email regarding tax withholding as a non-United States citizen. It is a pleasure to provide this for you.

A non-resident alien (NRA) is someone who maintains citizenship and residency outside of the United States and, as a result, is subject to different tax withholding and reporting rules than U.S. citizens and resident aliens. Tax withholding for a non-resident alien is determined by the country of residence, its tax treaty agreement with the United States and whether a properly completed Form W-8BEN has been received by TIAA-CREF. It is up to you to ensure all proper tax forms are received at the time you submit the forms to begin payments.

Non-resident aliens are generally subject to federal income tax in the United States on income received from United States sources. Money earned while a resident of the United States will be considered to have come from a U.S. source. U.S. source income also includes the earnings on retirement/pension funds created and held in the U.S.

How much tax is withheld depends on whether the country of residence has a treaty with the United States. The existence of a tax treaty between the United States and another nation permits either exemption from tax withholding or reduction of the tax-withholding rate."

Maybe I am being paranoid, but I don't see anywhere that they have acknowledged that as a UK resident, UK citizen, non-US citizen, non-US resident, I will be exempt from US income tax. In other words, this looks like a cookbook cut and paste from some guidelines they have, not a response to my individual request for clarification of my case.

Am I asking too much for them to confirm their understanding of the situation specifically for a UK resident, UK citizen, non-US citizen, non-US resident?

They have acknowledged that a DTA can reduce or eliminate the withholding tax and also exempt you from US taxation. So all you have to do is file the W-8BEN and claim 0% withholding on your IRA/401a etc withdrawals and cite Article 17.

If you claim zero withholding and owe the 10% early withdrawal penalty you'll have to file a 1040-NR. You definitely can't use FTCs to offset the 10% penalty because it is classed as "Other taxes", and they simply get added onto your total tax bill at the end of the 1040.