This is a complicated area but it does provide scope for some effective planning using foreign tax credits and Double Taxation Agreements. This is a very brief summary, you should seek professional advice if you wish to consider some of these issues in more detail.
Both the UK and the US provide tax incentives for retirement using pension schemes. Contributions made to a pension receive tax relief (up to certain limits) and growth within the plan is not currently taxed. If preferred, tax will only arise when monies are distributed from the pension plan.
The UK and US have entered into a Double Taxation Agreement that deals with pension schemes and pension income. Some significant points arising from this agreement are as follows;
- Contributions (employee and employer) into a UK pension can obtain tax relief in the US.
- Growth in the value of a UK pension can be claimed as tax free in the US.
- Pensions are generally taxed in the State where you are resident, not by the State from where the pension is paid.
- Pensions that are tax free in one State are tax free in the other State.
- Lump sums that are paid out of a pension in one State are tax free in the other State.
These are very general points. US citizens should always consider the “savings clause” (paragraph 1(4) of the Treaty) when considering what US tax relief is available. The “savings clause” essentially allows the US to disregard parts of the Treaty for US citizens.
There are several types of UK pensions; employer final salary plans, employer defined contribution plans and personal pensions (SIPPS).
Tax relief is provided at source on the contributions made into the pension in one of two ways. Either the personal contribution reduces taxable income providing full tax relief, or it is provided at the basic rate (20%) and higher rate relief is claimed on the Tax Return. Employer contributions are not subject to UK tax.
A non-working spouse may make gross annual contributions to a UK pension of £3,600 and receive 20% tax relief.
Contributions may be made by non-UK residents (limited to the amount of their UK earnings in the tax year). Therefore, if you receive deferred UK earnings after you leave the UK it is possible to make pension contributions and claim UK tax relief.
The maximum amount of qualifying pension contributions is currently £40,000 per year. The amount of annual contributions, while subject to the overriding £40,000 maximum is also limited to your earnings in the tax year, or £3,600. The £40,000 limit on pension contributions for years after 5th April 2016 is reduced, by £1 for every £2 that your income (plus employer pension contributions) exceeds £150,000, to a minimum of £10,000.
If you do not use your full annual pension allowance in a year, in some circumstances you can carry the unused relief forward for up to 3 years to make additional contributions in the current tax year in respect of unused relief from prior years.
The UK taxation of the payment of UK pensions will crucially depend upon where you are resident when you receive the pension. If you are resident in a country that has an appropriate Double Tax Agreement with the UK it will be exempt from UK tax and potentially subject to tax in that other country.
UK pensions are not qualifying US plans, the existence of the UK/US Tax Treaty (DTA) generally provides you with a choice between
- Do not claim relief under the DTA, claim no US tax relief on your pension contributions and include any employer contributions as current income. If your earnings are fully subject to UK tax these UK taxes will more than likely cover any additional US tax liability on your, and your employers, pension contributions. These contributions can subsequently be paid to you free of US tax. If you are resident in the US at that time there will be no UK tax either.
- Claim relief under the DTA, the US will provide tax relief on personal contributions and employer contributions are not taxable. However, the US tax arising on pension payments, will likely be able to benefit from any unused foreign tax credits that may be available.
Thus, you do have some discretion now how you treat UK pension contributions and also the final tax treatment of any pension distributions.
UK tax rates are higher than those in the US and you will generally pay more UK tax than you are able to use on your US Tax Return. This excess tax credit can carry forward for up to 10 years before expiring. Pensions allow you to reduce your UK tax and the amount of unused UK tax credits on your US return.
Where you have pension contributions that have not suffered US tax it may be possible to use up old credits, that may be expiring, by transferring UK pension monies into other plans and not claiming US Tax Treaty relief on the transfer.
The use of lump sums payments also attracts specific tax relief in the UK and also under the tax Treaty and may also be used in the context of optimising your pension position.
The most common form of US pensions for UK based US taxpayers are 401k plans (employer sponsored and funded by employee and employer contributions) and IRAs (Traditional and Roth) that are set up and funded by individuals. 401k monies can be rolled into an IRA tax free and funds in an IRA can be rolled into a Roth IRA; the transfer to a Roth IRA is subject to US tax but there is no early withdrawal penalty.
Contributions to Traditional IRAs can qualify for US tax relief whereas contributions into Roth IRAs get no tax relief. However, distributions from a Roth IRA are tax free (US and UK) whereas Traditional IRA/401K distributions are at least partly taxable and may be fully taxable.
Distributions from IRA or 401k plans are subject to US tax but, to the extent that a part of the taxable distribution is considered to be non-US source, the tax charged on that part of the distribution can be offset by available UK tax credits. The non-US source part of any 401k or IRA is that part that relates to contributions that were made when you were working or living outside the United States.
Monies held within a Roth IRA are tax free on distribution and it may be advisable to roll-over from a 401k/IRA into a Roth IRA. If this occurs when you are outside the US, the effective tax rate applied to the taxable distribution will likely be lower as a result of the impact of foreign tax credits. It will also avoid any State taxation. This is even the case where the monies in the 401k or IRA are 100% US source.
Although IRAs (Traditional and Roth) are not qualifying UK pensions, you cannot claim any UK tax relief on the contributions, the UK will not tax any income or gains arising on monies held in the IRAs. These are more effective than UK savings plans such as ISAs which do not have tax free status in the US.
As stated above, this is a basic summary of the rules and opportunities that may be available. These areas are complex and you should seek professional assistance if you wish to explore these in more detail. PJD Tax can assist if required.
Other articles of interest - UK Pension Contribution Allowance