Pension pot in overseas scheme - tax treatment

B1ng0

Would a pension pot held in a US retirement plan by a UK resident be liable to UK tax before reaching pension age? I'm only referring to the tax liability of the pension pot itself and its growth, not of any actual pension or lump sum withdrawn from the plan (which will of course be taxed when received). 

EdSwippet

B1ng0 said:

Would a pension pot held in a US retirement plan by a UK resident be liable to UK tax before reaching pension age?

Generally, no. From article 18 paragraph 1 of the US/UK tax treaty (country names in {} are mine):

Where an individual who is a resident of a Contracting State {the UK} is a member or beneficiary of, or participant in, a pension scheme established in the other Contracting State {the US}, 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).

So under the treaty, taxable only on withdrawals. As far as the treaty is concerned, reaching some "pension age", however defined, is irrelevant.

B1ng0

EdSwippet said:

B1ng0 said:

Would a pension pot held in a US retirement plan by a UK resident be liable to UK tax before reaching pension age?

Generally, no. From article 18 paragraph 1 of the US/UK tax treaty (country names in {} are mine):

Where an individual who is a resident of a Contracting State {the UK} is a member or beneficiary of, or participant in, a pension scheme established in the other Contracting State {the US}, 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).

So under the treaty, taxable only on withdrawals. As far as the treaty is concerned, reaching some "pension age", however defined, is irrelevant.

Thank you, very useful info. Does "income earned" include interest/dividends generated by the scheme and reinvested in it? 

EdSwippet

B1ng0 said:
Does "income earned" include interest/dividends generated by the scheme and reinvested in it? 

I'm not entirely clear what you're asking here; or perhaps more accurately, why you're asking it. Superficially though, I'd say "yes". Fundamentally, under the US/UK treaty, you have no UK (or US) tax liability whatsoever on your 401k or IRA, or on anything that goes on inside these plans, unless and until you take withdrawals from them.

By the way, one important note. I'm assuming here that you are not a US citizen or green card holder. If you are, some extra rules come into play, courtesy of the US's spiteful 'saving clause', treaty article 1 paragraph 4, which effectively guts most of the treaty specifically for 'US persons'. If you are a 'US person', then any withdrawals would be taxable for you to both countries, with article 24 paragraph 6 as your route to foreign tax credits so as to avoid pure double-tax.

B1ng0

EdSwippet said:

B1ng0 said:
Does "income earned" include interest/dividends generated by the scheme and reinvested in it? 

I'm not entirely clear what you're asking here; or perhaps more accurately, why you're asking it. Superficially though, I'd say "yes". Fundamentally, under the US/UK treaty, you have no UK (or US) tax liability whatsoever on your 401k or IRA, or on anything that goes on inside these plans, unless and until you take withdrawals from them.

By the way, one important note. I'm assuming here that you are not a US citizen or green card holder. If you are, some extra rules come into play, courtesy of the US's spiteful 'saving clause', treaty article 1 paragraph 4, which effectively guts most of the treaty specifically for 'US persons'. If you are a 'US person', then any withdrawals would be taxable for you to both countries, with article 24 paragraph 6 as your route to foreign tax credits so as to avoid pure double-tax.

Sorry about any confusion, I'm not too familiar with these subjects and probably don't always use the correct terms.
Basically, the balance in the retirement plan is invested in investment funds, whose overall value grows with time, and I just wanted to confirm that the tax-exempt status also applies to the growth itself, that is, to the interest (or whatever is called) gradually generated by the investments, which stays and is reinvested in the plan. 
Also, I'm not a "US person".  

EdSwippet

B1ng0 said:

Basically, the balance in the retirement plan is invested in investment funds, whose overall value grows with time, and I just wanted to confirm that the tax-exempt status also applies to the growth itself, that is, to the interest (or whatever is called) gradually generated by the investments, which stays and is reinvested in the plan.  

It does. Up to a point then, your 401k/IRA will behave as a UK SIPP. Dividends, interest, capital gains, and so on generated within these plans are all fully tax-sheltered until withdrawals, which are then UK taxable.

"Up to a point" because (a) there is of course no 25% tax-free PCLS; and (b), treaty article 17 paragraph 2 allows the US to tax "lump-sums":

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

The fun part of this clause is that nobody knows how to interpret it in practice (including the boneheaded treaty authors, it seems). Nowhere do the treaty or its notes define "lump-sum", and the two countries use this term both loosely and differently in their domestic tax law, depending on context. Completely unsatisfactory of course, but then that's UK and US tax law all over.

B1ng0

EdSwippet said:

B1ng0 said:

Basically, the balance in the retirement plan is invested in investment funds, whose overall value grows with time, and I just wanted to confirm that the tax-exempt status also applies to the growth itself, that is, to the interest (or whatever is called) gradually generated by the investments, which stays and is reinvested in the plan.  

It does. Up to a point then, your 401k/IRA will behave as a UK SIPP. Dividends, interest, capital gains, and so on generated within these plans are all fully tax-sheltered until withdrawals, which are then UK taxable.

"Up to a point" because (a) there is of course no 25% tax-free PCLS; and (b), treaty article 17 paragraph 2 allows the US to tax "lump-sums":

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

The fun part of this clause is that nobody knows how to interpret it in practice (including the boneheaded treaty authors, it seems). Nowhere do the treaty or its notes define "lump-sum", and the two countries use this term both loosely and differently in their domestic tax law, depending on context. Completely unsatisfactory of course, but then that's UK and US tax law all over.

OK, thank you! Basically, I'll have to worry about tax only when starting to withdraw a pension or lump sum from this plan. 

Bostonerimus1

B1ng0 said:

EdSwippet said:

B1ng0 said:

Basically, the balance in the retirement plan is invested in investment funds, whose overall value grows with time, and I just wanted to confirm that the tax-exempt status also applies to the growth itself, that is, to the interest (or whatever is called) gradually generated by the investments, which stays and is reinvested in the plan.  

It does. Up to a point then, your 401k/IRA will behave as a UK SIPP. Dividends, interest, capital gains, and so on generated within these plans are all fully tax-sheltered until withdrawals, which are then UK taxable.

"Up to a point" because (a) there is of course no 25% tax-free PCLS; and (b), treaty article 17 paragraph 2 allows the US to tax "lump-sums":

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

The fun part of this clause is that nobody knows how to interpret it in practice (including the boneheaded treaty authors, it seems). Nowhere do the treaty or its notes define "lump-sum", and the two countries use this term both loosely and differently in their domestic tax law, depending on context. Completely unsatisfactory of course, but then that's UK and US tax law all over.

OK, thank you! Basically, I'll have to worry about tax only when starting to withdraw a pension or lump sum from this plan. 

You don't need to worry about US or UK tax until withdrawals are made. When you do make withdrawals you will have to pay income tax. If you are making regular withdrawals then you will declare those as foreign pension payments on your UK tax return. The US DC pension administrator might withhold 30% of these "overseas payments" and you will have to file a 1040NR to claim that tax back.

As Ed says the "lump sum" confusion continues and is just best avoided unless there is some well researched tax advantage to be gained and or you just want to take out the entire amount which would be a lump sum in the US and the UK. 

EdSwippet

Bostonerimus1 said:

As Ed says the "lump sum" confusion continues and is just best avoided ...

It may be hard or impossible to avoid. From a Vanguard communication sent out last year:

We're writing to inform you of an update to the U.S. tax withholding rate for distributions from your IRA at Vanguard.

A nonresident alien is an individual who's not a U.S. citizen or a resident of the U.S. Nonresident aliens are subject to U.S. income tax on income from sources within the U.S.

In general, nonresident aliens who are citizens of the United Kingdom and India are subject to a 30% tax withholding rate on IRA withdrawals. The income tax treaties between the U.S. and the United Kingdom and India do permit plan administrators to apply a reduced withholding rate to distributions that aren't lump-sum distributions; however, there's no clear definition of a lump-sum distribution.

So, to be conservative, as of January 1, 2024, Vanguard will withhold 30% from each IRA distribution to a nonresident alien of the United Kingdom or India.

If you're eligible for a lower rate, you may file a request with the IRS for a refund of any excess taxes withheld. Please consult your tax advisor if you have any questions about your specific situation.

That is, Vanguard now considers every withdrawal, no matter how small or regular, to be a "lump-sum". On later query, Vanguard confirmed that this blanket 30% US withholding also includes any and all qualified Roth IRA withdrawals.

Bostonerimus1

The OP might not be dealing with Vanguard.

30% withholding is withheld from foreign pension payments and Vanguard is just giving another justification here. They obviously expect the Treaty provisions to be claimed on the 1040NR and regular payments from an IRA etc won’t be lump sums to the IRS. Actually it’s often advantageous to have just the US taxing your IRA distributions on things like IRA to ROTH rollovers where the US tax rates are better than the UKs so lump sum distributions would be a good thing for many.

EdSwippet

Bostonerimus1 said:

The OP might not be dealing with Vanguard. I think Vanguard would find it difficult to justify the lump sum argument for payments made on a regular schedule and when filing the 1040NR I’d claim it back. It’s an important distinction as HMRC needs to be on that same page.

Vanguard don't need to justify it. They've simply mandated this policy by fiat, and that's that.

Claiming the withholding back on a 1040NR is not without its own problems. Paper filing only, and a wait of perhaps 18 months to two years before you see the refund from the IRS. Meanwhile, the IRS has interest-free use of your money. And in the case of a Roth, the overwithholding refund cannot be put back into the Roth account, which leads to a significant loss of tax sheltered headroom.

(For UK readers not familiar with the terminology here, a Roth IRA is approximately equivalent to an ISA. That is, it is composed of post-tax contributions. This is what makes applying withholding tax to every Roth IRA withdrawal so pernicious; it is no different to facing tax withholding on ISA withdrawals.)