Inherited 401(k) and tax implications

There are a number of ways you can approach the taxation of the Inherited IRA. Often there isn't a single answer.

1) for UK tax purposes treat it just like an inheritance, this will avoid tax on the capital, but you'll be left with having to pay UK tax on the annual gains.

2) treat it like a foreign pension and pay income tax on withdrawals. This might be easier if you are taking income over a number of years.

I believe that with inherited IRA's then withdrawals usually have to begin the following year, the % determined by the age of the new owner.

If you are really allowed to use option 1) then that would probably be the better option since you only ever have to pay tax on the gains rather tax on the entire amount which you have to start drawing on immediately.

I believe that with inherited IRA's then withdrawals usually have to begin the following year, the % determined by the age of the new owner.

Yes, I believe the rule is you have to start taking MRDs in the year following the year of death of the IRA owner.  In my case, it's a sibling who died in May 2016 so I have to start taking MRDs from my Inherited IRA by 31 December 2017.  As I'm a dual UK/US citizen with a UK (foreign) address, Vanguard has to withhold 10% Fed tax, but I may be able to get that 10% back on filing my 1040 for 2017 in 2018. (If I wasn't a US citizen, it would be 30% withheld with a foreign address.)

If you are really allowed to use option 1) then that would probably be the better option since you only ever have to pay tax on the gains rather tax on the entire amount which you have to start drawing on immediately.

Whether option 1) is allowed or not is a key question. I'm tempted to phone to the HMRC and ask.

You don't have to use the treaty, but I imagine once you make a decision of how to treat the IRA for UK tax purposes you probably should not change it.

The OP inherited a sum of money inside an IRA. If the treaty is not used the UK will look through the IRA and tax the assets inside.....no tax on the capital, but tax on any gains. I think this is a good way to go if you take the IRA out all at once rather than doing RMDs.

If the OP decides to use the treaty then there is no UK tax on the rollover to the inherited IRA, but the usual IRA/pension dance will have to be done depending on citizenship and residency.

The OP inherited a sum of money inside an IRA. If the treaty is not used the UK will look through the IRA and tax the assets inside.....no tax on the capital, but tax on any gains. I think this is a good way to go if you take the IRA out all at once rather than doing RMDs.

At the same time, I also received an Inherited Roth IRA (much smaller in value, dang it  ).  Applying your logic and the treaty is not used, then the HMRC would look thru the Roth IRA wrapper ... no tax on the capital but tax on any gains.  So in this case I would need to use the treaty to prevent tax on any gains, or use the treaty and take it as a tax free lump sum.

At the same time, I also received an Inherited Roth IRA (much smaller in value, dang it  ).  Applying your logic and the treaty is not used, then the HMRC would look thru the Roth IRA wrapper ... no tax on the capital but tax on any gains.  So in this case I would need to use the treaty to prevent tax on any gains, or use the treaty and take it as a tax free lump sum.

For a ROTH you'd use the treaty and there will be no tax in the US or the UK.

The OP inherited a sum of money inside an IRA. If the treaty is not used the UK will look through the IRA and tax the assets inside.....no tax on the capital, but tax on any gains. I think this is a good way to go if you take the IRA out all at once rather than doing RMDs.

If the OP decides to use the treaty then there is no UK tax on the rollover to the inherited IRA, but the usual IRA/pension dance will have to be done depending on citizenship and residency.

Just to be clear, I'm a US citizen and have freedom to work in the U.K.  There would be no capital gains on the IRA because I took a distribution-in-full as soon as the paperwork was sent, however it's this distribution that I'm curious about since it was taxed as income in the US. In my situation there won't be a rollover or conversion, the money is sitting in a US bank account for the time being but I plan to wire it to my personal account in the UK.

Just to be clear, I'm a US citizen and have freedom to work in the U.K.  There would be no capital gains on the IRA because I took a distribution-in-full as soon as the paperwork was sent, however it's this distribution that I'm curious about since it was taxed as income in the US. In my situation there won't be a rollover or conversion, the money is sitting in a US bank account for the time being but I plan to wire it to my personal account in the UK.

The simplest thing to do seems to be to just treat the IRA as an inheritance. If there have been no gains in the IRA after you inherited then there will be no UK tax. You will have to pay US tax on the distribution though.

Nun, I phoned the HMRC this morning.  You're right, from a UK tax perspective, an inherited IRA can be treated just like an inheritance.  There's no tax on the capital, just tax on any gains.  Interestingly, it said this applies regardless of the frequency of receipts including RMDs.  And Article 17 isn't applicable because it's an inheritance.  This applies to inherited IRAs and annuities.

For self-assessment purposes, if each payment received is broken down by the financial institution into capital and any gain, then just report the gain.  If it's not broken down, you can make an approximation of any gain and report that.  In either case, you just report any gain and provide a brief explanation in the white space.

Nun, I phoned the HMRC this morning.  You're right, from a UK tax perspective, an inherited IRA can be treated just like an inheritance.  There's no tax on the capital, just tax on any gains.  Interestingly, it said this applies regardless of the frequency of receipts including RMDs.  And Article 17 isn't applicable because it's an inheritance.  This applies to inherited IRAs and annuities.

For self-assessment purposes, if each payment received is broken down by the financial institution into capital and any gain, then just report the gain.  If it's not broken down, you can make an approximation of any gain and report that.  In either case, you just report any gain and provide a brief explanation in the white space.

The difficulty in paying tax on the gains is that the money might be invested in non-reporting funds and you'd have to do some leg work to workout the actual gains.

For long term holding of the IRA and withdrawals it's probably best to treat it like a pension and pay UK tax and then resource to get the FTCs for US taxes as it will all be income.

The HMRC has a list of reporting funds, 203 of which are for Vanguard funds.  (Probably a dumb question, but would I need to restrict myself to those 66 Vanguard funds with a CUSIP number?)
https://www.gov.uk/government/publications/offshore-funds-list-of-reporting-funds

What's wrong with just keeping the IRA invested in those funds?  Or are you saying that working out the actual gains would still require too much leg work?

The HMRC has a list of reporting funds, 203 of which are for Vanguard funds.  (Probably a dumb question, but would I need to restrict myself to those 66 Vanguard funds with a CUSIP number?)
https://www.gov.uk/government/publications/offshore-funds-list-of-reporting-funds

What's wrong with just keeping the IRA invested in those funds?  Or are you saying that working out the actual gains would still require too much leg work?

I keep my IRA's invested in mutual funds because all withdrawals are treated as regular income anyway, because of the pension wrapper.

I keep my after tax investments in Vanguard equity ETF's with CUISP numbers that are HMRC reporting because then HMRC treats the dividends like equity dividends with lower taxation than if the dividends were treated as regular income.

The HMRC has a list of reporting funds, 203 of which are for Vanguard funds.  (Probably a dumb question, but would I need to restrict myself to those 66 Vanguard funds with a CUSIP number?)
https://www.gov.uk/government/publications/offshore-funds-list-of-reporting-funds

What's wrong with just keeping the IRA invested in those funds?  Or are you saying that working out the actual gains would still require too much leg work?

If the funds are inside an IRA and you are using the treaty pension articles then it doesn't matter if the funds are UK reporting or not. If you choose not to use the treaty and pay UK tax on the gains you should US reporting funds as that would be most UK tax efficient, but Vanguard won't send you a statement for the annual gains.....you'll have to work them out for yourself.

I keep my IRA's invested in mutual funds because all withdrawals are treated as regular income anyway, because of the pension wrapper.

I keep my after tax investments in Vanguard equity ETF's with CUISP numbers that are HMRC reporting because then HMRC treats the dividends like equity dividends with lower taxation than if the dividends were treated as regular income.

Just out of curiosity, were your IRAs set-up by yourself or were they inherited?

If the funds are inside an IRA and you are using the treaty pension articles then it doesn't matter if the funds are UK reporting or not. If you choose not to use the treaty and pay UK tax on the gains you should US reporting funds as that would be most UK tax efficient, but Vanguard won't send you a statement for the annual gains.....you'll have to work them out for yourself.

Based on my phone call with the HMRC (a tax inspector familiar with the treaty), the treaty isn't applicable at all to an Inherited IRA because it's an inheritance.  That said, I suspect that you could still regard it as pension under the treaty without any consequences.

I'm curious as to why you say that:

For long term holding of the IRA and withdrawals it's probably best to treat it like a pension and pay UK tax and then resource to get the FTCs for US taxes as it will all be income.

Why would taking it as income and paying UK tax be more tax efficient than paying UK tax on any gains?  Or are you considering that fact that IRA income would still be taxable in the USA which couldn't be offset by FTCs if gains are just taxed?  (Apologies for any stupidity on my part.)

The difficulty in paying tax on the gains is that the money might be invested in non-reporting funds and you'd have to do some leg work to workout the actual gains.

For long term holding of the IRA and withdrawals it's probably best to treat it like a pension and pay UK tax and then resource to get the FTCs for US taxes as it will all be income.

After reading this, I was thinking that perhaps a good answer is simply take a lump sum distribution of the whole thing. Yes, a big us tax bite all at once, but no uk tax as it is an inheritance and a new baseline for cap gains.

The downside is losing potential tax-delayed gains on the money that goes for taxes in year 0 .... but unless we think there'll be a big bull market that loss should be offset by future year tax savings. 

Just a thought - thankfully my aged parent is in good health, but some day this will be an issue for me .


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I'm curious as to why you say that:Why would taking it as income and paying UK tax be more tax efficient than paying UK tax on any gains?  Or are you considering that fact that IRA income would still be taxable in the USA which couldn't be offset by FTCs if gains are just taxed?  (Apologies for any stupidity on my part.)

It's more for convenience than anything else. If you have to pay tax on the IRA withdrawals in the US they are taxed as income and if you have a UK tax liability it's easy to take the FTC and you don't have the hassle of doing the accounting of the dividends and the gains and dealing with the whole reporting funds issues.

Actually I suppose for the UK you could say that you have a tax free basis if the IRA is inherited and the only UK taxable income would be on the gains....which would be taxed as income and you could get a FTC on the US tax liability.

So here's a thought for an inherited IRA.

1) If you take the distribution all at once then you pay US tax and there is no UK tax to pay on the capital as it's an inheritance.

2) If you keep the inherited IRA and do RMDs then US tax is due on the withdrawals, but for the UK the original capital is a tax free basis and you only pay income tax on amounts in excess of that capital.