The US-UK Pension Tax Treaty
Explore the US-UK Pension Tax Treaty and discover how it affects expats. Get essential insights to navigate your tax obligations effectively.
Introduction
If you are an expat moving between the UK and the USA, whether for work or retirement, you will be faced with many financial decisions. Amongst the most important of these is how your pension will be taxed.
Whether you have contributed to a UK pension but now live in the United States, or vice versa, the rules regarding pension taxation can be confusing.
Fortunately, the US and the UK have a tax treaty, or double taxation agreement, in place, which can offer some relief, but only if navigated correctly.
Our guide will highlight the key details of the tax treaty, how it works, and how to leverage it to your advantage.
By the end of this article, you will understand:
- What a tax treaty is
- What the US-UK tax treaty covers and how this can affect your pension
- How to use the US-UK tax treaty to your advantage as an expat
- How you may still be able to take your UK tax-free lump sum even if you now live in the USA
- What steps to take next
What is the US-UK Tax Treaty and How Does it Affect Pensions?
Definition:
A tax treaty, also known as a double taxation agreement, is a legal agreement between two jurisdictions or countries which defines which one has the right to tax certain kinds of income, how double taxation can be avoided, and how residents or citizens of one jurisdiction are treated when they receive income in the other. The UK and the USA have a tax treaty in place, and it covers various forms of income from wages and pensions to interest and dividends. Article 17 of the treaty deals with pensions specifically, and states how pension distributions (including lump sums) from one country are taxed when the recipient is in the other country. Understanding this provision is crucial for any individuals who hold UK pensions and have US tax obligations, such as US Citizens, tax residents or Green Card holders.
The Difference Between UK Taxation and US Taxation
To gain a true understanding of the benefits of this tax treaty, it's important to first grasp the differences of how pensions are taxed in both the UK and the US:
UK Pension Taxation
The UK allows individuals to take a Pension Commencement Lump Sum (PCLS), commonly up to 25% of the value of a pension pot, completely tax-free, subject to limits.
After this lump sum is taken, the remaining pension payments or withdrawals will be taxed at the recipient’s standard income tax rates.
Whilst In the past, there was a lifetime allowance (LTA) which was a limit on the total amount of pension benefits an individual could take without incurring a significant tax charge, this has now been replaced with the lump sum allowance (LSA) and lump sum and death benefit allowance (LSDBA).
The LSA limits the total tax-free lump sum an individual can take from all their pensions to £268,275, and the LSDBA limits the total tax-free lump sums and tax-free death benefit lump sums that may be paid in relation to an individual’s pensions to £1,073,100.
US Taxation on UK Retirement Accounts
In the US, all citizens and many residents are taxed on their worldwide income. This means that payments or withdrawals from pensions accumulated abroad are typically taxed as ordinary income, unless a tax treaty provision dictates otherwise.
Typically, foreign pensions are not considered ‘qualified’ US retirement accounts, and therefore do not automatically receive the same tax-deferred or preferential status as they might in the UK.
How the US-UK Tax Treaty Can Benefit Expat Pensions
Article 17(1)(b) of the US-UK tax treaty states that distributions from pensions based in one treaty country may be exempt from taxation in the other country, under certain conditions. For UK pensions, this means a lump-sum withdrawal that is tax-free in the UK may also be tax-free in the US.
Article 17(2) states that lump sum withdrawals are only taxed in the country in which the pension is based. However, in practice there is a ‘savings clause’ in the treaty which limits the effect of some provisions. This clause ensures the US can still tax certain items, even if the treaty provision would otherwise exempt them.
The savings clause may undermine Article 17(2), but Article 17(1)(b) is generally not affected. Whilst a grey area, and potentially state dependant, the general conclusion that many expat tax specialists draw is that a UK pension lump sum (up to 25%) that is tax-free under UK law is also likely to be tax-free under US taxation, if the treaty is used correctly.
Tax Treaty Considerations
Whilst the US-UK tax treaty may help you to avoid US taxation when withdrawing your 25% tax-free lump sum from your UK pension, this is subject to several practical and important steps and rules which must be followed:
UK Rules
To meet the UK rules, your pension must allow a tax-free lump sum, you must be eligible for this in terms of age, and any other conditions stated by your pension provider. It's important to bear in mind that the value of the pension and any relevant lifetime allowances or protections can affect how much you are able to take tax-free.
US Treaty Requirements
To claim this treaty benefit, it's important to properly declare this when filing your US tax returns by using Form 8833 (Treaty-based Return Position Disclosure). You will also need to report any distributions, even if they are tax-exempt under the treaty, to avoid any penalties from the IRS.
Avoiding Double Taxation
After you’ve taken your lump sum, any subsequent distributions from the pension will likely be taxed by both countries under their respective rules (UK as per UK income tax, US as ordinary income). Under the treaty, you can generally use foreign tax credits (in the US) for UK-tax paid on the taxed portion, to avoid being taxed twice on the same income.
Savings Clause Limitations
The treaty’s savings clause means the US retains the right to tax citizens or tax residents as if the treaty does not apply, except for certain specific provisions such as Article 17(1)(b).
Long-Term Planning
There are various important factors to consider when it comes to long-term planning, such as how much you withdraw, when, your total income in both UK and US, currency fluctuations. There may be better strategies than taking the lump sum available to you- for example, spreading income so you stay in lower US tax brackets, or delaying withdrawals.
It's important to work with a specialised adviser to ensure you are making the most tax-efficient choices for your personal circumstances.
Risks To Be Aware Of
Changes in law: Over time, Pension rules, tax rates and treaty interpretations may change. The rules regarding lifetime allowances or lump sums may shift, so it’s important to keep up to date with changing regulations.
Failure to Report correctly: When using the tax treaty, it is essential to remain fully compliant with tax reporting and to be aware of the requirements. You could risk being audited if any documentation is incomplete or if your use of the treaty is not properly disclosed. Seek advice from a specialised cross-border adviser to ensure you remain on the right side of both HMRC and the IRS and to avoid any penalties.
Currency risk: As currency exchange rates fluctuate between USD and GBP, so can the value of your pension and the amount of tax due. Currency risk may affect whether taking a lump sum now or waiting for more favourable market conditions makes more sense financially.
How to Use the US-UK Tax Treaty For Your Pension
If you believe that you may qualify to benefit from the tax treaty provisions for your pension, here are the next steps you should take:
Check that your pension provider permits tax-free lump sums, and confirm that you meet all of the UK criteria to take this (minimum age, etc.)
Estimate your total tax exposure in both countries by combining your worldwide income.
Consult a cross-border tax specialist, regulated to provide advice in both the UK and the USA. It’s important to get specialised advice from experts who are well versed in the tax laws of both jurisdictions to ensure compliance.
Gather evidence and supporting documentation which illustrates how you meet the tax treaty conditions.
File the appropriate US tax forms, such as form 8833, when claiming tax treaty benefits and report your UK pension accurately.
At The Wealth Genesis, we help expats between the US and the UK get the most out of their pensions, with the right financial planning and understanding of tax laws and treaties. We can help ensure that your tax burdens are as light as possible, whilst remaining fully compliant.
To learn more, book a free discovery call today.
