U.S. Tax Treatment of U.K. Retirement & Pension Plans
Few things are more confusing for U.K. foreign nationals and U.S. expats residing in the U.K. than the U.S. tax code, especially as it applies to cross-border pensions. Here’s a short primer for the dazed and confused.
Types of U.K. Pensions
U.K. pensions can be grouped into 4 categories:
- Private pensions: These are pensions that are arranged by the individual with a financial institution. Upon retirement, 25% of the pension can be withdrawn tax-free in the U.K. The remainder can be used to purchase a lifetime annuity, or continued to be invested in the pension. A common private pension is a SIPP.
- Workplace pensions: A workplace pension us set up by an employer. Both the employee and employer pay into the pension. The employee’s contribution is tax-free. The 25% tax-free distribution upon retirement applies to workplace pensions also.
- Defined benefit plans: The pension amount is based on the employee’s final salary.
- State pensions: State pensions (aka Government Pension or Old Age Pension) are based on the number of years of National Insurance (NI) contributions made by the employee.
Step 1: Defined benefit vs. defined contribution foreign pensions
The U.S. tax treatment of foreign pensions can be downright confusing. The first step is classifying the foreign pension under the U.S. code – which sometimes feels like fitting a square peg in a round hole. To make matters confusing, even the same type of pension can have different tax treatment depending on how it’s structured. All pensions plans are either defined benefit or defined contribution:
- A defined benefit plan provides a specified payment amount upon retirement.
- A defined contribution plan allows employees and employers to contribute and invest the funds over time; the amount in the pension will depend on the investment growth.
Some practitioners take the position that a defined benefit retirement plan isn’t really an account, so it does not need to be reported on the FBAR or Form 8938. It might not be an account, but it is a specified foreign financial asset. Consistent with Form 8938 instructions, we either use the distribution amount as the fair market value of the defined benefit pension. If no distribution was made during the year, then the value is $0.
If you have a defined benefit plan, consider yourself lucky. You report the distributions as taxable income, fill out Form 8938, and you’re done. There are very rare exceptions for defined benefit plans which are considered not “broad-based”. Owners of defined contribution plans can read further.
Step 2: Employees’ trust vs. grantor trust
In the U.S., qualified pension plans such as a 401(k) have favorable tax treatment – taxes on investment growth is deferred until retirement. In order for a defined benefit pension or retirement account to qualify for this favorable tax treatment, there are detailed and stringent rules that must be met.
Very few foreign pensions qualify under for deferred tax-treatment under IRC 401. There are none in the U.K. that we’ve encountered.
A non-qualifying defined benefit pension plan is by default a trust. As a trust it can be an employees’ trust under IRC 402 or a grantor trust. Most U.K. private pensions will be considered grantor trusts. Defined benefit workplace pensions might be either.
A plan is self-funded if more than 50% of the assets in the plan are attributable to the employee’s contributions. And if so, the pension would be reported as a grantor trust. Generally, the owner of a foreign pension classified as a grantor trust would file Form 3520 and Form 3520-A, and report the capital gains on the growth of the investment. However, as we’ll see below, the U.S.-U.K. tax treaty provides some relief there.
Step 3: Broad-based & non-discriminatory
If the plan is not considered self-funded, then it is an employee’s trust and falls within the domain of IRC 402. Within IRC 402, there is a maze of further classification rules.
Is the plan broad-based and non-discriminatory? Under a broad-based plan (which meets both coverage and participation tests), the pension is not taxed until distribution. If a plan is non-broad-based then highly-compensated employees will be taxed on earnings within the pension. A highly-compensated employee is one that has either a 5% or greater owner of the company or has compensation of at least $120,000 annually (periodically inflation adjusted).
U.S.-U.K. Tax Treaty
To keep things simple, here’s a watered-down version of Articles 17 and 18 of the tax treaty for U.S. residents with U.K. pensions:
Generally, all U.K. pension distributions paid to a U.S. resident are taxable in the U.S. and only by the U.S., except:
- Any amounts that would’ve been excluded from tax in the U.K. had that person remained a U.K. resident, would also be excluded from U.S. tax. For example, if 25% of a distribution from a SIPP would be excluded in the U.K., that is also excluded in the U.S.
- Distributions from U.K. social security type pensions are taxable only in the U.K.
Further, Article 18 provides relief from tax on earnings to those with pensions classified as grantor-trusts or discriminatory employees’ trusts. Article 18 provides that a pension scheme established in the U.K. is taxed only when distributed (and not transferred to another pension scheme). The later part is interpreted that a U.K. pension rollover to a another U.K pension is not a taxable event in the U.S. But be careful not to rollover into a U.S. pension – which would be a taxable event! (See IRS Chief Counsel Memorandum).
In addition to treaty relief, foreign tax credits can be claimed on the U.S. return for any taxes paid on the same income in the U.K. The foreign earned income exclusion is not available for pension income.
In addition to reporting all taxable income and applicable international information returns, the taxpayer should also disclose all treaty positions on Form 8833, other than those that are not required under IRC 6114 or 7701(b).
Kunal Patel, J.D. attorney, comes from a diverse background that includes IRS, Big 4 public accounting, and legal experience. He focuses almost exclusively in offshore compliance matters and has successfully brought numerous taxpayers into compliance with with U.S. tax laws concerning offshore accounts and income.
We assist taxpayers who have undisclosed foreign financial assets. Schedule an appointment to see how we can help.