401k => Roth IRA

Hi
I saw lots of people mention they have converted their 401k to Roth IRA before they move to the U.K.  What are the benefits of that?

My wife has a small leftover sum in her 401k from her days in the States and she’s now converted to full-time motherhood in the U.K. So that account is not likely to grow too much but I’m trying to plan what’s best for the future. Any ideas what to do with the 401k?

Cheers
Kalo

You can't access 401k or IRA money until age 59.5 without a 10% penalty and you can't move it tax free into any UK equivalent.

Converting it to a Roth IRA means paying tax on the withdrawal but no penalty and it grows tax free then is tax free in both countries when withdrawals are made.  Converting it before moving back to the UK means for sure you will only pay US taxes which are often lower than UK taxes, but may not be. For example your wife may have little to no income when she is able to take money from her 401k penalty free.  For example suppose her UK income is £5k/year, then she could start withdrawing £5k/year from her 401k and pay no UK taxes.  (If you are filing MFJ in the USA then her 401k withdrawal will add to your joint income and potentially be taxed in the USA).

Converting it to a Roth IRA means paying tax on the withdrawal but no penalty and it grows tax free then is tax free in both countries when withdrawals are made.  Converting it before moving back to the UK means for sure you will only pay US taxes which are often lower than UK taxes, but may not be. For example your wife may have little to no income when she is able to take money from her 401k penalty free.  For example suppose her UK income is £5k/year, then she could start withdrawing £5k/year from her 401k and pay no UK taxes.  (If you are filing MFJ in the USA then her 401k withdrawal will add to your joint income and potentially be taxed in the USA).

Thanks for the advice. Few more questions:

• Are you able to convert to Roth IRA after you’ve moved to the U.K.?
• If you have no income in US/U.K., how much tax do you pay on the conversion?
• Once the money is in the Roth account and the withdrawals are tax-free in both countries, can you not withdraw all of it in 1 go? Do you need to file a tax return in the states and self-assessment in that case?

Thanks for the advice. Few more questions:

• Are you able to convert to Roth IRA after you’ve moved to the U.K.?
• If you have no income in US/U.K., how much tax do you pay on the conversion?
• Once the money is in the Roth account and the withdrawals are tax-free in both countries, can you not withdraw all of it in 1 go? Do you need to file a tax return in the states and self-assessment in that case?

1. Yes but you need to have a Roth IRA into which to move it. Once resident in the UK you may find it impossible to open a new IRA or Roth IRA to receive the transfer. So before leaving it is definitely worth Rolling the 401k into an IRA which is a tax free event and also opening a Roth IRA within the same brokerage to make future IRA to Roth IRA conversions possible, and easy to do.

2. It all depends on the size of the conversion and how you are filing taxes in the USA. Your wife may have no income but you have not said, or I missed  what your citizenship and filing status is. Google will tell you the standard deduction for the filing status being used then all income below that deduction will be tax free.

3. There are specific rules about taxes and penalties if withdrawing from a Roth before age 59.5. Money from the Roth can be withdrawn in any quantity including all at once. No need to declare Roth withdrawals to HMRC but I think you will have to file a tax return in the US even if it turns out that no taxes are due. this is because of the peculiar Roth taxation rules, at a minimum, even at age 65 you will be asked if you have owned a Roth IRA for at least 5 years.

Durhamlad covered all the salient points, but I'll add:

• Withdrawing money from a Roth IRA within 5 years of putting it in makes the earnings on that contribution taxable again.
  
  
• 401ks and IRA are subject to Required Minimum Distributions (RMDs) starting April 1st following age 72. Roth IRAs are not subject to RMD until you die.
  
  
• The reason why Roth conversions are popular with UK/US investors living in the UK is that for the vast majority their UK tax bill is higher than their US tax bill. This effectively reduces their US tax bill to zero. Since the Roth conversion is only taxable on the US side, people can use their yearly US tax free allowance to slowly move their 401k's and Traditional IRA's into their Roth IRA without paying taxes to anyone, even if they are a high earner in the UK. When they later want to withdraw the money (and its earnings) it's tax free on both sides. It's one of the few ways to avoid (rather than just delay) income tax.
  
  
• In general, you don't have to file a US return provided your worldwide income is less than the standard deduction and you are not self-employed. Exact rules here. As long as the amount you rolled over + the rest of your worldwide income was less than the amount in table 1 of the above link, I don't think you have to file, but working it out may be hard enough that you find yourself buying the guided filing software and doing all the work anyway (at which point you may as well finish up and file!). While there is an official IRS wizard for determining if your Roth IRA distribution (withdrawal) is taxable, some of the questions are esoteric, and good filing software is a godsend here.

Here's my take on the subject of Roth Conversions and the US UK DTA


US/UK DTA Extracts
ARTICLE 17
Pensions, social security, annuities, alimony, and child support
1. (a) Pensions and other similar remuneration beneficially owned by a
resident of a Contracting State shall be taxable only in that State.

(b) Notwithstanding sub-paragraph a) of this paragraph, the amount of
any such pension or remuneration paid from a pension scheme established in the other
Contracting State that would be exempt from taxation in that other State if the
beneficial owner were a resident thereof shall be exempt from taxation in the first mentioned
State.

2. Notwithstanding the provisions of paragraph 1 of this Article, a lump-sum
payment derived from a pension scheme established in a Contracting State and
beneficially owned by a resident of the other Contracting State shall be taxable only in
the first-mentioned State.

ARTICLE 18
1. Where an individual who is a resident of a Contracting State is a member
or beneficiary of, or participant in, a pension scheme established in the other
Contracting State, income earned by the pension scheme may be taxed as income of
that individual only when, and, subject to paragraphs 1 and 2 of Article 17 (Pensions,
Social Security, Annuities, Alimony, and Child Support) of this Convention, to the
extent that, it is paid to, or for the benefit of, that individual from the pension scheme
(and not transferred to another pension scheme).

IRS definition of a lump-sum distribution:

''A lump-sum distribution is the distribution or payment within a single tax year of a plan participant's entire balance from all of the employer's qualified plans of one kind (for example, pension, profit-sharing, or stock bonus plans).''

I seems clear from the above that only one single lump-sum distribution can ever be made from one single account. As such, according to the DTA, multiple lump-sum distributions are subject to UK tax.


401k/IRA Rollover is a US tax exempt transaction and is reported as a non taxable event on Form 1099-R and Form 5498 or alternatively Form 1042-S if Form W-8BEN is filed and active with the provider. As such, according to the DTA, it is tax exempt in the UK

IRA Roth Conversion is not a US tax exempt transaction, it is reported as a taxable distribution from a 401k/Trad IRA account and then a separate deposit of that distribution to an existing Roth IRA account and is reported as such on Form 1099-R and Form 5498 or alternatively Form 1042-S if Form W-8BEN is filed and active with the provider. As such, according to the DTA, it is subject to UK tax.

A Rollover is not a Conversion and a Conversion is not a Rollover. Very distinct differences.

IRS definition of a lump-sum distribution:

''A lump-sum distribution is the distribution or payment within a single tax year of a plan participant's entire balance from all of the employer's qualified plans of one kind (for example, pension, profit-sharing, or stock bonus plans).''

I seems clear from the above that only one single lump-sum distribution can ever be made from one single account. As such, according to the DTA, multiple lump-sum distributions are subject to UK tax.

A ROTH IRA, unlike a 401k, is not a employer qualified plan.

Here's https://expattaxprofessionals.com/blog/article/roth-ira-taxation-expats-in-uk take on Roth IRA taxation in the UK:

Roth IRA – UK Taxation of Pension Distributions
Article 17 of the Treaty distinguishes between periodic and lump-sum payments. In the case of periodic payments, Article 17(1) states that the state of residence (in our case, the UK) has the exclusive right to tax pensions, but must exempt from tax any amount of such pensions that would be exempt from tax in the State in which the pension scheme is established if the recipient were a resident of that State (in our case, the U.S.).

Fortunately, the U.S. Treasury Department’s Technical Explanation to the Treaty explains Article 17(1) using the Roth IRA as an illustrative example. The Technical Explanation states, “Thus, for example, a distribution from a U.S. ‘Roth IRA’ to a UK resident would be exempt from tax in the United Kingdom to the same extent the distribution would be exempt from tax in the United States if it were distributed to a U.S. resident.”

Thus, since the U.S. exempts Roth IRA distributions from taxation, the UK should seemingly be obliged to do the same for periodic pension payments under the Treaty.

In the case of lump-sum payments, Article 17(2) states more simply that any lump-sum payment derived by a resident of a Contracting State (in our case, the UK) from a pension scheme established in the other Contracting State shall be taxable only in that other State (in our case, the U.S.). Thus, since a Roth IRA is established in the U.S., it apparently cannot be taxed in the UK under the Treaty.

A ROTH IRA, unlike a 401k, is not a employer qualified plan.

Here's https://expattaxprofessionals.com/blog/article/roth-ira-taxation-expats-in-uk take on Roth IRA taxation in the UK:

That is correct. Roth Distributions are UK tax exempt, Roth Conversions are not.

That is correct. Roth Distributions are UK tax exempt, Roth Conversions are not.

Above you quoted the IRS definition of a lump sum from a retirement account.  Since we are talking about whether or not the UK taxes a retirement lump sum isn’t it more important to look at the HMRC definition?

There are endless discussions on the subject both here and other forums (fora?) what do the dual taxation companies have to say about it I wonder?

Above you quoted the IRS definition of a lump sum from a retirement account.  Since we are talking about whether or not the UK taxes a retirement lump sum isn’t it more important to look at the HMRC definition?

According to the DTA the US retains taxing rights to lump-sum distributors therefore the IRS definition is what counts.

According to the DTA the US retains taxing rights to lump-sum distributors therefore the IRS definition is what counts.

There is no doubt whatsoever that the IRS taxes a lump sum conversion from an IRA to a Roth. The question is whether the UK also taxes that lump sum. If not and your marginal tax rate in the UK is higher than in the US  then you are better off doing Roth conversions.

I did my Roth conversations because I knew that when OAP and SS start I would be in the 40% HMRC tax bracket. I started the conversations the year after I retired so most of it was done before I returned to the UK 7 years later.

I’m now in the 40% bracket but Roth withdrawals are free of tax.

PS
SS and OAP are only taxed in the UK for a US person living in the UK

There is no doubt whatsoever that the IRS taxes a lump sum conversion from an IRA to a Roth. The question is whether the UK also taxes that lump sum. If not and your marginal tax rate in the UK is higher than in the US  then you are better off doing Roth conversions.

Yes, but bear in mind the IRS definition of a lump-sum and one realizes that for the purposes of the DTA multiple conversions are not.

I had previously carried out some conversions and paid estimated US tax thinking this was correct only to receive Form 1042-S indicating that the conversion was US tax exempt according the DTA. Subsequently I filed a 1040-NR return claiming a substantial refund of those estimated taxes explaining I had paid estimated US tax in error as the transaction was US tax exempt according to the DTA and Form 1042-S. Refund was duly deposited to my designated US bank account. I have now rethought my strategy for repatriating my US based IRA monies and will no longer take the conversion route but will delay taking UK OAP and US SS till i have emptied those IRA accounts in the 20% bracket.

So I pay slightly more UK tax than I would have paid US on any conversions because NRA's do not receive the US individual allowance and pay tax on every penny at the marginal rate but the good thing is no more filing US tax returns for me from now on.

Yes, but bear in mind the IRS definition of a lump-sum and one realizes that for the purposes of the DTA multiple conversions are not.

I had previously carried out some conversions and paid estimated US tax thinking this was correct only to receive Form 1042-S indicating that the conversion was US tax exempt according the DTA. Subsequently I filed a 1040-NR return claiming a substantial refund of those estimated taxes explaining I had paid estimated US tax in error as the transaction was US tax exempt according to the DTA and Form 1042-S. Refund was duly deposited to my designated US bank account. I have now rethought my strategy for repatriating my US based IRA monies and will no longer take the conversion route but will delay taking UK OAP and US SS till i have emptied those IRA accounts in the 20% bracket.

So I pay slightly more UK tax than I would have paid US on any conversions because NRA's do not receive the US individual allowance and pay tax on every penny at the marginal rate but the good thing is no more filing US tax returns for me from now on.

Gotcha. 

I am a USC therefore am never non-resident so can't file 1040NR. OP never specified if his wife is a USC or not, and I have assumed that she is, which is my mistake.

OP,  if your wife  is not a USC then please ignore my advice as I have no experience of a UK person living in the UK still with a 401k in the USA. For sure the question of a rollover to an IRA or Roth IRA will likely be impossible unless she already has an existing account to take the rollover or conversion.

Thanks @DaveB , @Ukraideruk & @durhamlad. Lots and lots to digest. Could you please help me solidify my understanding so far?

In summary:

• Step 1 is to roll over the 401k to a traditional IRA and open a Roth IRA within the same provider for Step 2. This is exempt from taxes in both countries but it has to be reported as a non-taxable event when filing your tax returns in the States. Does my wife need to submit a self-assessment on the back of this in the U.K.?
• Step 2 is to start converting the IRA amount to Roth IRA which adds to your taxable gross income but as she’s unemployed we could convert less than the standard deduction per year and not pay any tax. As far as I understand the standard deduction for married people filling separately is $12,550. So as long as we stay under that amount we won’t pay any taxes.
• Step 3 is to withdraw the funds when she’s over 59.5 as a lump sum which will not be taxed in neither US, nor U.K. A bit confused here - if you withdraw this in chunks, it will be taxed in the U.K.?

Thanks very much
Kalo