How are 401K lump sums treated?

TBalias

My wife and I have reasonable 401K pots, having worked in the US in the late 90s. In looking at how to draw down from these pots tax efficiently I have remaining questions. Several key points have been raised here before e.g. filling a W8-BEN to remove US tax withholdings. We are both over 59.5 so no early withdrawal penalties.  I have read the US/UK tax treaty para 17 which is clear on regular withdrawals, but less clear on lump sums.

My understanding of the tax treaty is that a one off 25% lump sum withdrawal would be taxed at 30% in the US even if a W8-BEN has been filed, as lump sums are taxed on local terms, but that this should be reclaimable via 1064NR. Any clarifications?

Also I'm unclear if HMRC would treat that lump sum once repatriated as a pension lump sum i.e. tax free, as it would be for a UK pension pot, or as income as for regular disbursements.

Any experiences?

EdSwippet

TBalias said:

I have read the US/UK tax treaty para 17 which is clear on regular withdrawals, but less clear on lump sums.

The language used in treaty article 17(2) is relatively clear overall (interpolations are mine): "2. Notwithstanding the provisions of paragraph 1 of this Article, a lump-sum payment derived from a pension scheme established in a Contracting State (US) and beneficially owned by a resident of the other Contracting State (UK) shall be taxable only in the first-mentioned State. (US)"

However ... nowhere does the treaty define "lump-sum". There are different interpretations of this, and although not relevant to a 401(k) specifically, the UK's use of 'pension commencement lump sum' is a perennial source of confusion. Taking your entire 401(k) in one go is fairly clearly a "lump-sum". Taking some of it every month is clearly not. Is taking 25% of it once a lump-sum? What about if you take 25% next year also; is that two lump-sums, or something regular? You see the problem here.

Beyond this, although superficially this says that only the US may tax a "lump-sum" (however defined), treaty article 1(4) -- the 'saving clause' -- potentially overrides this. Potentially, because it is generally only the US that wields this clause, against its own citizens living outside the US.

So if a "lump-sum", taxable to the US, but less clear on the UK side. Now, at what US rate? Again, there are several schools of thought. The basic US rule is that absent treaty cover, you pay US graduated rates on the proportion of the withdrawal that is from your own contributions, and 30% on the part from investment growth. However, again the treaty has something to say on this; not least the non-discrimination clause that says that the US cannot apply worse tax results to UK residents than if the same person where still a US resident. And US residents would pay 'effectively connected income' (graduated) rates, not 30% flat, on 401(k) withdrawals.

Not even close to clear, is it? All of this with the assumption that you are not a US citizen or a green card holder. If you are, this quagmire only gets worse. A lot worse.

TBalias said:

IMy understanding of the tax treaty is that a one off 25% lump sum withdrawal would be taxed at 30% in the US even if a W8-BEN has been filed, as lump sums are taxed on local terms, but that this should be reclaimable via 1064NR. Any clarifications?

Given article 17(2), which give the US the right to tax a "lump-sum", it seems highly unlikely that a 1040-NR would or could recover any entire 30% US tax withholding. You could probably recover some of it, but only after working out what your US tax liability on this amount actually is (assuming it comes to below 30%), and as noted above, this in itself is far from simple.

The main thing to note here is that any tax withholding applied by the platform will be at best a guess of the amount owed, and almost certainly an overestimate (the US regularly overwithholds rather than underwithholds, to ensure that taxpayers have a positive motivation to file a US tax return).

TBalias said:

Also I'm unclear if HMRC would treat that lump sum once repatriated as a pension lump sum i.e. tax free, as it would be for a UK pension pot, or as income as for regular disbursements.

They certainly will not treat it as equivalent to a UK 25% tax-free PCLS. Entirely different setup. What they may do is treat it as not UK taxable because treaty article 17(1) reserves taxing rights on a "lump-sum" (again, however defined) from a 401(k) to the US.

TBalias

Thank you  EdSwippet, clear explanation of a complex topic. Will need time to digest, but It would appear the regular withdrawal route is simpler and possibly less fraught, with limited tax benefits of the lump sum route.

Bostonerimus1

It is helpful to understand that the IRS considers a "lump sum" to be the complete distribution of an account in a single tax year. This is an IRS definition and something solid to hold onto. So as long as you are an NRA anything less than a 100% 401k distribution should not be liable to US tax...there could well be withholding that you will have to claim back using the tax treaty. Then I would expect to pay UK income tax on those 401k distributions, there's no need to worry about HMRC's definition of "lump sum", and enter them as foreign pension income when you file your HMRC self assessment. 

WastedWords

From this HMRC forum discussion it appears that HMRC consider that "Article 1(4) effectively ‘overrides’ the provision at Article 17(2), and the consequence is that both the UK and USA can tax any lump sum payment received from a US sourced pension scheme."

(Note: to avoid 2 pages of conflicting and confusing posts, start on page 3 with the first post by HMRC Admin 19).

EdSwippet

WastedWords said:

From this HMRC forum discussion it appears that HMRC consider that "Article 1(4) effectively ‘overrides’ the provision at Article 17(2), and the consequence is that both the UK and USA can tax any lump sum payment received from a US sourced pension scheme."

I have seen this discussion before. It offers a master-class in HMRC's inability to comprehend and engage with a simple and clearly worded question, alongside showing their inability to come up with any useful answer once they have apparently understood it.

There are two problems with HMRC's differentiation of 'lump sum' and 'periodic'.

The first is, simply, that HMRC's interpretation of 'lump sum' and the IRS's interpretation of 'lump sum' are different. Unless and until these two agree, the entire area is simply grey and undefined.

The second is a logical error in HMRC's interpretation. They offer this:

For example, the first (IRA) withdrawal is taken in year 1, the next withdrawal was made in year 5, and another withdrawal in year 7; such payments will not be regarded as periodic and will be treated as Lump Sum’s under the UK/USA DTA. Whereas any amount withdrawn in set, periodic, frequent intervals (e.g. weekly, monthly, annually etc.) would not be a Lump Sum, but rather periodic payments.  

The problem occurs after year 1. At that point, you have to file both US and UK tax returns. On those returns, is this year 1 withdrawal (a) the first of a periodic series, and so taxable only to the UK, or (b) a one-off lump sum and so taxable to the US and potentially also the UK (with the UK forced to give credit for US tax paid)?

The answer is: it's unresolvable until some arbitrary and undefined future date. Schrodinger's withdrawal. Utterly unsatisfactory.